EXHIBIT 13
FINANCIAL HIGHLIGHTS
FISCAL YEARS ENDED NOVEMBER 30, 2006 2005 2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
(in thousands, except common share data,
financial ratios and other data)
- ------------------------------------------------------------------------------------------------------------------------------------
RESULTS
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 9,227,165 $ 7,410,794 $ 6,812,883 $ 5,994,491 $ 5,128,236
Employee compensation and benefits 4,343,499 3,553,216 3,253,862 2,880,695 2,508,197
Non-compensation expenses 1,737,036 1,650,519 1,536,867 1,341,527 1,309,076
Total expenses 6,080,535 5,203,735 4,790,729 4,222,222 3,817,273
Net income $ 2,053,871 $ 1,462,177 $ 1,344,733 $ 1,156,406 $ 878,345
Net income applicable to common shares $ 2,032,508 $ 1,437,856 $ 1,316,661 $ 1,125,031 $ 842,739
- ------------------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
- ------------------------------------------------------------------------------------------------------------------------------------
Total assets(1) $350,432,595 $287,292,637 $252,112,691 $209,181,240 $181,452,776
Long-term borrowings $ 54,569,916 $ 43,489,616 $ 36,843,277 $ 29,430,465 $ 23,681,399
Guaranteed Preferred Beneficial
Interests in Company Subordinated
Debt Securities(2) $ -- $ -- $ -- $ 562,500 $ 562,500
Stockholders' equity $ 12,129,384 $ 10,791,432 $ 8,990,872 $ 7,470,088 $ 6,382,083
- ------------------------------------------------------------------------------------------------------------------------------------
COMMON SHARE DATA
- ------------------------------------------------------------------------------------------------------------------------------------
Basic earnings per share $ 15.79 $ 11.42 $ 10.88 $ 9.44 $ 7.00
Diluted earnings per share $ 14.27 $ 10.31 $ 9.76 $ 8.52 $ 6.47
Cash dividends declared per
common share $ 1.12 $ 1.00 $ 0.85 $ 0.74 $ 0.62
Book value per common share $ 86.39 (3) $ 71.08 $ 59.13 $ 48.69 $ 39.94
Common shares outstanding(4) 145,693,021 146,431,767 144,484,099 142,369,836 145,591,496
- ------------------------------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
- ------------------------------------------------------------------------------------------------------------------------------------
Return on average common equity 19.1% 16.5% 19.1% 20.2% 18.1%
Profit margin(5) 34.1% 29.8% 29.7% 29.6% 25.6%
- ------------------------------------------------------------------------------------------------------------------------------------
OTHER DATA
- ------------------------------------------------------------------------------------------------------------------------------------
Assets under management (in billions) $ 52.5 $ 41.9 $ 37.8 $ 29.2 $ 24.0
Average value-at-risk (in millions) $ 28.6 $ 20.5 $ 15.8 $ 15.8 $ 16.5
Employees 13,566 11,843 10,961 10,532 10,574
(1) As of November 30, 2006, the Company elected, under FIN No. 39,
"Offsetting Amounts Related to Certain Contracts," to net cash collateral
received or paid against its derivatives inventory, on a counterparty
basis, provided that the legal right of offset exists. The Consolidated
Statements of Financial Condition as of November 30, 2005, 2004, 2003, and
2002 have been adjusted to conform to the current year's presentation.
(2) In accordance with FIN No. 46 (R) the Company has deconsolidated Bear
Stearns Capital Trust III effective beginning with the quarter ended
February 29, 2004. As a result, the Debentures issued by the Company to
Bear Stearns Capital Trust III are included within long-term borrowings.
The $262.5 million of Preferred Securities issued by Capital Trust III is
still outstanding, providing the funding for such Debentures. The
Preferred Securities issued by Capital Trust III are no longer included in
the Company's Consolidated Statements of Financial Condition. As of
November 30, 2003 and 2002, Guaranteed Preferred Beneficial Interests in
Company Subordinated Debt Securities consists of $300 million of Preferred
Securities issued by Bear Stearns Capital Trust II and $262.5 million of
Preferred Securities issued by Bear Stearns Capital Trust III.
(3) For book value purposes, at November 30, 2006, common stockholders' equity
was adjusted by $816 million and common stock outstanding was adjusted by
4.6 million units, which represents stock-based compensation associated
with fiscal 2006 awards that was reflected in stockholders' equity as of
the grant date in December 2006, in accordance with SFAS No. 123 (R),
"Share-based Payment." In previous years, stock-based compensation granted
in December was included in stockholders' equity at November year-end.
(4) Common shares outstanding include units issued under certain stock
compensation plans, which will be distributed as shares of common stock.
(5) Represents the ratio of income before provision for income taxes to
revenues, net of interest expense.
FINANCIAL REPORT
Table of Contents
Management's Discussion and Analysis of Financial Condition and Results
of Operations
Introduction 32
Certain Factors Affecting Results of Operations 32
Forward-Looking Statements 32
Executive Overview 33
Results of Operations 35
Liquidity and Capital Resources 44
Off-Balance-Sheet Arrangements 56
Derivative Financial Instruments 57
Critical Accounting Policies 58
Accounting and Reporting Developments 61
Effects of Inflation 62
Risk Management
Overall 63
Market Risk 64
Credit Risk 68
Operational Risk 71
Legal Risk 72
Other Risks 72
Management's Report on Internal Control over Financial Reporting 73
Report of Independent Registered Public Accounting Firm 74
Report of Independent Registered Public Accounting Firm 75
Consolidated Financial Statements
Consolidated Statements of Income 76
Consolidated Statements of Financial Condition 77
Consolidated Statements of Cash Flows 78
Consolidated Statements of Changes in Stockholders' Equity 79
Notes to Consolidated Financial Statements
Note 1 Summary of Significant Accounting Policies 81
Note 2 Fair Value of Financial Instruments 87
Note 3 Financial Instruments 88
Note 4 Derivatives and Hedging Activities 88
Note 5 Transfers of Financial Assets and Liabilities 90
Note 6 Variable Interest Entities and Mortgage Loan Special Purpose
Entities 92
Note 7 Collateralized Financing Arrangements 93
Note 8 Short-Term Borrowings 94
Note 9 Long-Term Borrowings 95
Note 10 Preferred Stock 96
Note 11 Earnings Per Share 97
Note 12 Employee Benefit Plan 98
Note 13 Stock Compensation Plans 98
Note 14 Customer Activities 102
Note 15 Income Taxes 103
Note 16 Regulatory Requirements 105
Note 17 Commitments and Contingencies 106
Note 18 Guarantees 107
Note 19 Segment and Geographic Area Data 109
Note 20 Quarterly Information (Unaudited) 112
Corporate Information
Price Range of Common Stock and Dividends and Related Stockholder Matters 113
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company") is a holding company that
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is a leading investment banking, securities and derivatives trading, clearance
and brokerage firm serving corporations, governments, and institutional and
individual investors worldwide. BSSC, a subsidiary of Bear Stearns, provides
professional and correspondent clearing services in addition to clearing and
settling customer transactions and certain proprietary transactions of the
Company. The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Custodial
Trust Company; Bear Stearns Financial Products Inc. ("BSFP"); Bear Stearns
Capital Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex
Inc.; EMC Mortgage Corporation; Bear Stearns Commercial Mortgage, Inc.; and
through its majority owned subsidiary Bear Hunter Holdings LLC. The Company is
primarily engaged in business as a securities broker-dealer operating in three
principal segments: Capital Markets, Global Clearing Services and Wealth
Management. As used in this report, the "Company" refers (unless the context
requires otherwise) to The Bear Stearns Companies Inc. and its subsidiaries.
Unless specifically noted otherwise, all references to fiscal 2006, 2005 and
2004 refer to the twelve months ended November 30, 2006, 2005 and 2004,
respectively.
CERTAIN FACTORS AFFECTING RESULTS OF OPERATIONS
The Company's principal business activities--investment banking, securities and
derivatives sales and trading, clearance, brokerage and asset management--are,
by their nature, highly competitive and subject to various risks, including
volatile trading markets and fluctuations in the volume of market activity.
Consequently, the Company's net income and revenues have been, and are likely to
continue to be, subject to wide fluctuations, reflecting the effect of many
factors, including general economic conditions, securities market conditions,
the level and volatility of interest rates and equity prices, competitive
conditions, liquidity of global markets, international and regional political
conditions, regulatory and legislative developments, monetary and fiscal policy,
investor sentiment, availability and cost of capital, technological changes and
events, outcome of legal proceedings, changes in currency values, inflation,
credit ratings and the size, volume and timing of transactions.
These and other factors can affect the Company's volume of new securities
issuances, mergers and acquisitions and business restructurings; the stability
and liquidity of securities and futures markets; and the ability of issuers,
other securities firms and counterparties to perform on their obligations. A
decrease in the volume of new securities issuances, mergers and acquisitions or
restructurings generally results in lower revenues from investment banking and,
to a lesser extent, reduced principal transactions. A reduced volume of
securities and futures transactions and reduced market liquidity generally
results in lower revenues from principal transactions and commissions. Lower
price levels for securities may result in a reduced volume of transactions, and
may also result in losses from declines in the market value of securities held
in proprietary trading and underwriting accounts. In periods of reduced sales
and trading or investment banking activity, profitability may be adversely
affected because certain expenses remain relatively fixed. The Company's
securities trading, derivatives, arbitrage, market-making, specialist, leveraged
lending, leveraged buyout and underwriting activities are conducted on a
principal basis and expose the Company to significant risk of loss. Such risks
include market, counterparty credit and liquidity risks. For a discussion of how
the Company manages risks, see the "Risk Management" and "Liquidity and Capital
Resources" sections in this report.
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
stringent regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
FORWARD-LOOKING STATEMENTS
Certain statements contained in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements concerning management's expectations, strategic
objectives, business prospects, anticipated economic performance and financial
condition and other similar matters are subject to risks and uncertainties,
including those described in the preceding paragraph, which could cause actual
results to differ materially from those discussed in the forward-looking
statements. Forward-looking statements speak only as of the date of the document
in which they are made. We disclaim any obligation or undertaking to provide any
updates or revisions to any forward-looking statement to reflect any change in
our expectations or any change in events, conditions or circumstances on which
the forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
A generally favorable operating environment characterized by an expanding US
economy and active equity and fixed income markets provided a healthy climate
for the Company's businesses during fiscal 2006. Revenues, net of interest
expense ("net revenues"), for the fiscal year ended November 30, 2006 increased
24.5% to a record $9.23 billion from $7.41 billion for the fiscal year ended
November 30, 2005, while pre-tax earnings increased 42.6% during the same period
to $3.15 billion. The pre-tax profit margin for fiscal 2006 increased to 34.1%,
compared with 29.8% for fiscal 2005. Return on average common equity was 19.1%
for fiscal 2006, compared with 16.5% for fiscal 2005.
Capital Markets net revenues increased 27.9% to a record $7.32 billion for
fiscal 2006, compared with $5.72 billion for fiscal 2005. Within the Capital
Markets segment, institutional equities net revenues increased 35.7% to a record
$1.96 billion for fiscal 2006 from $1.45 billion for fiscal 2005. The increase
in institutional equities was driven by increases in equity derivatives,
international sales and trading, risk arbitrage and energy activities. Fixed
income net revenues reached record levels, increasing 27.2% to $4.19 billion for
fiscal 2006 from $3.29 billion for fiscal 2005. Mortgage-backed securities net
revenues increased during fiscal 2006 when compared with fiscal 2005 as
mortgage-backed securities origination volumes and secondary trading revenues
increased. Credit product net revenues reached record levels, reflecting record
results from the leveraged finance and distressed trading areas and improved
credit derivatives net revenues. Investment banking revenues increased 19.0% to
a record $1.17 billion for fiscal 2006 from $983.0 million for fiscal 2005,
primarily reflecting increases in advisory fee revenues and underwriting
revenues, partially offset by a decrease in merchant banking revenues.
Global Clearing Services net revenues increased 4.7% to a record $1.08 billion
for fiscal 2006 from $1.03 billion for fiscal 2005. An increase in average
customer margin balances, reflecting improved US equity markets, contributed to
an increase in net interest revenues, partially offset by a decline in
commission and other revenues.
Wealth Management net revenues increased 26.0% to a record $857.7 million in
fiscal 2006 from $680.5 million in fiscal 2005, reflecting higher asset
management revenues due to increased performance fees on proprietary hedge fund
products and increased management fees on higher levels of traditional assets
under management. Private Client Services ("PCS") also had increased net
interest revenues and increased net revenues associated with growth in fee-based
assets.
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Business Environment
Fiscal 2006
The business environment during the Company's fiscal year ended November 30,
2006 was generally favorable due to a combination of factors, including an
expanding US economy, improved corporate profitability, low unemployment and
moderate inflation. Favorable labor reports provided ongoing support to economic
activity in fiscal 2006. The unemployment rate dropped to 4.4% in October 2006,
its lowest level since August 2001 and ended fiscal 2006 at 4.5%. However,
rising energy prices continued to be a cause for concern throughout fiscal 2006,
as the price of oil increased from approximately $57 a barrel in December 2005
to a high of approximately $77 a barrel in August 2006. A decline in oil prices
during the fourth quarter of fiscal 2006 helped fuel a year-end rally in the
equity markets. The Federal Reserve Board (the "Fed") met eight times during
fiscal 2006 and raised the federal funds rate during each of its first five
meetings, in 25 basis point increments, from 4.00% to 5.25%, supported by gains
in productivity, relatively low core inflation and expansion in economic
activity. However, during its last three meetings of fiscal 2006, the Fed kept
the federal funds rate unchanged at 5.25%, citing a cooling of the housing
market and moderating economic growth from its strong pace earlier in the year.
Each of the major US equity indices increased during the fiscal year ended
November 30, 2006. The Standard & Poor's 500 Index ("S&P 500"), the Dow Jones
Industrial Average ("DJIA") and the Nasdaq Composite Index ("NASDAQ") increased
12.1%, 13.1% and 8.9%, respectively. Average daily trading volume on the New
York Stock Exchange ("NYSE") and the Nasdaq increased 5.5% and 10.3%,
respectively, compared with fiscal 2005. Industry-wide US-announced M&A volumes
increased 22.0% while industry-wide US-completed M&A volumes increased 40.7%,
compared with fiscal 2005. Total industry-wide equity issuance volumes increased
25.3%, while industry-wide initial public offering ("IPO") volumes increased
3.4%, compared with the levels reached during fiscal 2005.
Fixed income markets remained strong in fiscal 2006 despite challenges
associated with higher short-term interest rates and a flat yield curve.
Long-term rates, as measured by the 10-year Treasury bond, remained relatively
stable during fiscal 2006. At the close of fiscal 2006, the 10-year Treasury
bond yield was 4.46%, compared with 4.50% on November 30, 2005. US
mortgage-backed securities underwriting volumes increased 10.9% in fiscal 2006
compared with fiscal 2005 and continued to benefit from favorable market
conditions. Agency collateralized mortgage obligation ("CMO") volumes declined
15.9% industry-wide from the levels reached during fiscal 2005, reflecting
declining refinancing activity. However, non-agency mortgage-backed originations
increased 27.3%. The Mortgage Bankers Association Purchase Index decreased
approximately 12.9%, compared with fiscal 2005, as average 30-year fixed
mortgage rates increased and the home purchasing market cooled in fiscal 2006
compared with fiscal 2005.
Fiscal 2005
The business environment during the Company's fiscal year ended November 30,
2005 was generally favorable due to a combination of factors, including an
expanding US economy, improved corporate profitability and low inflation.
Favorable labor reports and an active housing market provided ongoing support to
economic activity in fiscal 2005. The unemployment rate dropped to 4.9% in
August 2005, its lowest level since August 2001 and ended fiscal 2005 at 5.0%.
However, rising energy prices continued to be a cause for concern throughout
fiscal 2005, as the price of oil increased from a low of approximately $41 a
barrel in December 2004 to a high of approximately $70 a barrel by the end of
August 2005, affected by hurricane-related supply disruptions. Rising energy
costs reinforced concerns by investors that the US economy would slow in the
second half of fiscal 2005. However, the US economy remained resilient. A number
of positive economic reports during the second half of fiscal 2005 and a
pullback in oil prices to $57 a barrel in November fueled a year-end rally in
the equity markets. The Fed met eight times during fiscal 2005 and raised the
federal funds rate each time, in 25 basis point increments, from 2.00% to 4.00%,
supported by gains in productivity, an increase in job growth and rising
consumer confidence.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Each of the major US equity indices increased during the fiscal year ended
November 30, 2005. The S&P 500, the DJIA and the NASDAQ increased 6.4%, 3.6% and
6.5%, respectively. Average daily trading volume on the NYSE and the NASDAQ
increased 9.4% and 3.9%, respectively, compared with fiscal 2004. Industry-wide
US-announced M&A volumes increased 52% while industry-wide US-completed M&A
volumes increased 8%, compared with fiscal 2004. Total equity issuances,
including IPO volumes, declined 11% and 14%, respectively, compared with the
levels reached during fiscal 2004.
Fixed income markets continued to be robust in fiscal 2005 despite a more
challenging environment associated with higher short-term interest rates and a
flattening yield curve. Long-term rates, as measured by the 10-year Treasury
bond, remained relatively stable during fiscal 2005. At the close of fiscal
2005, the 10-year Treasury bond yield was 4.50%, compared with 4.36% on November
30, 2004. Mortgage-backed securities underwriting volumes continued to benefit
from favorable market conditions. Agency CMO volumes declined industry-wide from
the levels reached during fiscal 2004, but were offset by an increase in
non-agency mortgage-backed originations. The Mortgage Bankers Association
Purchase Index increased approximately 5%, compared with fiscal 2004, as
continued low long-term interest rates fueled a strong home purchasing market.
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results
for the fiscal years ended November 30, 2006, 2005 and 2004:
- ---------------------------------------------------------------------------------------------------------------------
(in thousands, except per share
amounts, pre-tax profit margin
and return on average common % Increase
equity) 2006 2005 2004 2006/2005 2005/2004
- ---------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 9,227,165 $ 7,410,794 $ 6,812,883 24.5% 8.8%
Income before provision
for income taxes $ 3,146,630 $ 2,207,059 $ 2,022,154 42.6% 9.1%
Net income $ 2,053,871 $ 1,462,177 $ 1,344,733 40.5% 8.7%
Diluted earnings per share $ 14.27 $ 10.31 $ 9.76 38.4% 5.6%
Pre-tax profit margin 34.1% 29.8% 29.7%
Return on average common equity 19.1% 16.5% 19.1%
- --------------------------------------------------------------------------------------------------------------------
The Company reported net income of $2.05 billion, or $14.27 per share (diluted),
for fiscal 2006, which represented an increase of 40.5% from $1.46 billion, and
38.4% from $10.31 per share (diluted), respectively, for fiscal 2005. The
Company reported net income of $1.34 billion for fiscal 2004, or $9.76 per share
(diluted).
Fiscal 2006 versus Fiscal 2005 Net revenues increased 24.5% to $9.23 billion in
fiscal 2006 from $7.41 billion in fiscal 2005 due to increases in principal
transactions revenues, investment banking revenues, net interest revenues and
asset management and other revenues, partially offset by a decrease in
commission revenues.
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
The Company's commission revenues by reporting category for the fiscal years
ended November 30, 2006, 2005 and 2004 were as follows:
- --------------------------------------------------------------------------------------------------------------
% Increase (Decrease)
2006 2005 2004 2006/2005 2005/2004
- --------------------------------------------------------------------------------------------------------------
(in thousands)
- --------------------------------------------------------------------------------------------------------------
Institutional $ 786,359 $ 776,900 $ 703,593 1.2% 10.4%
Clearance 233,805 260,889 303,194 (10.4%) (14.0%)
Retail 142,522 162,665 171,287 (12.4%) (5.0%)
- --------------------------------------------------------------------------------------------------------------
Total commissions $ 1,162,686 $ 1,200,454 $ 1,178,074 (3.1%) 1.9%
==============================================================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Commission revenues in fiscal 2006 decreased 3.1% to $1.16 billion from $1.20
billion in fiscal 2005. Institutional commissions increased 1.2% to $786.4
million from $776.9 million in fiscal 2005 due to increased average daily
trading volumes. Clearance commissions decreased 10.4% to $233.8 million in
fiscal 2006 from $260.9 million in fiscal 2005, primarily reflecting lower
average rates from prime brokerage and fully disclosed clients. Retail
commissions decreased 12.4% to $142.5 million in fiscal 2006 from $162.7 million
in fiscal 2005 due to the transition of certain accounts from a commission-based
to a fee-based platform.
The Company's principal transactions revenues by reporting category for the
fiscal years ended November 30, 2006, 2005 and 2004 were as follows:
- ---------------------------------------------------------------------------------------------------------------------
% Increase (Decrease)
2006 2005 2004 2006/2005 2005/2004
- ---------------------------------------------------------------------------------------------------------------------
(in thousands)
- ---------------------------------------------------------------------------------------------------------------------
Fixed income $ 3,617,359 $ 2,998,286 $ 3,071,960 20.6% (2.4%)
Equities 1,377,653 837,731 523,635 64.5% 60.0%
- ---------------------------------------------------------------------------------------------------------------------
Total principal transactions $ 4,995,012 $ 3,836,017 $ 3,595,595 30.2% 6.7%
=====================================================================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Revenues from principal transactions in fiscal 2006 increased 30.2% to $5.00
billion from $3.84 billion in fiscal 2005. Fixed income revenues increased 20.6%
to $3.62 billion for fiscal 2006 from $3.00 billion for fiscal 2005, primarily
attributable to an increase in net revenues in the mortgage-backed securities,
distressed trading and credit derivatives areas. Mortgage-backed securities
revenues increased during fiscal 2006 when compared with fiscal 2005 on higher
origination volumes from asset-backed securities, adjustable rate mortgage
("ARM") securities and commercial mortgage-backed securities, as well as
increased secondary trading revenues, particularly in non-agency mortgage-backed
securities, asset-backed securities and ARMs. Revenues derived from distressed
trading increased as corporate credit spreads tightened and customer activity
increased during fiscal 2006. Revenues from the leveraged finance business
increased significantly, associated with increased acquisition finance activity.
Additionally, revenues from credit derivatives increased due to higher customer
activities reflecting favorable market conditions. Revenues derived from the
Company's equities activities increased 64.5% to $1.38 billion in fiscal 2006
from $837.7 million in fiscal 2005. Net revenues from equity derivatives rose on
favorable market conditions and increased customer activity. Equity revenues
from the Company's international equity sales and trading business also
increased, which benefited from higher average daily trading volumes and
increased market share in both European and Asian equities. Revenues from the
risk arbitrage area increased due to higher global announced M&A volumes. In
addition, fiscal 2006 included gains on the Company's sale of certain commodity
assets as well as gains on the Company's investment in the NYSE Group Inc.
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
The Company's investment banking revenues by reporting category for the fiscal
years ended November 30, 2006, 2005 and 2004 were as follows:
- ------------------------------------------------------------------------------------------------------------
% Increase (Decrease)
2006 2005 2004 2006/2005 2005/2004
- ------------------------------------------------------------------------------------------------------------
(in thousands)
- ------------------------------------------------------------------------------------------------------------
Underwriting $ 514,698 $ 470,910 $ 433,437 9.3% 8.6%
Advisory and other fees 707,093 412,689 350,727 71.3% 17.7%
Merchant banking 111,960 153,614 246,887 (27.1%) (37.8%)
- ------------------------------------------------------------------------------------------------------------
Total investment banking $ 1,333,751 $ 1,037,213 $ 1,031,051 28.6% 0.6%
============================================================================================================
Investment banking revenues increased 28.6% to $1.33 billion in fiscal 2006 from
$1.04 billion in fiscal 2005. Underwriting revenues increased 9.3% to $514.7
million in fiscal 2006 from $470.9 million in fiscal 2005, primarily due to
higher levels of high yield and high grade underwriting activity. Partially
offsetting these increases was a decline in equity underwriting revenues
reflecting lower levels of equity underwriting activity. Advisory and other fees
for fiscal 2006 increased 71.3% to $707.1 million from $412.7 million for fiscal
2005, reflecting a significant increase in completed M&A assignments during
fiscal 2006. Merchant banking revenues include realized and unrealized
investment gains and performance fees on managed merchant banking funds.
Merchant banking revenues decreased 27.1% to $112.0 million for fiscal 2006 from
$153.6 million for fiscal 2005, reflecting lower net gains on the Company's
portfolio of investments and lower performance fees on managed merchant banking
funds.
Net interest revenues (interest and dividends revenue less interest expense)
increased 25.5% to $1.21 billion in fiscal 2006 from $965.4 million in fiscal
2005. The increase in net interest revenues was primarily attributable to higher
levels of customer interest-bearing balances and improved net interest margins.
Average customer margin debt balances increased 5.4% to $68.4 billion in fiscal
2006 from $64.9 billion in fiscal 2005. Average customer short balances
decreased 2.1% to $82.6 billion in fiscal 2006 from $84.4 billion in fiscal 2005
and average securities borrowed balances decreased 7.4% to $55.0 billion in
fiscal 2006 from $59.4 billion in fiscal 2005.
Asset management and other revenues increased 40.9% to $523.9 million for fiscal
2006 from $371.7 million for fiscal 2005, primarily reflecting increased
performance fees on proprietary hedge fund products and increased management
fees on higher levels of traditional assets under management. PCS fees also
increased due to higher levels of fee-based assets.
Fiscal 2005 versus Fiscal 2004 Net revenues increased 8.8% to $7.41 billion in
fiscal 2005 from $6.81 billion in fiscal 2004 due to increases in all revenue
categories, including net interest revenues, principal transactions revenues,
commission revenues, investment banking revenues and asset management and other
revenues.
Commission revenues in fiscal 2005 increased 1.9% to $1.20 billion from $1.18
billion in fiscal 2004. Institutional commissions increased 10.4% to $776.9
million from $703.6 million in fiscal 2004 due to increased average daily
trading volume on the NYSE and market share improvement. Clearance commissions
decreased 14.0% to $260.9 million in fiscal 2005 from $303.2 million in fiscal
2004, primarily reflecting lower trading volumes and rates from prime brokerage
clients. Retail commissions decreased 5.0% to $162.7 million in fiscal 2005 from
$171.3 million in fiscal 2004.
Revenues from principal transactions in fiscal 2005 increased 6.7% to $3.84
billion from $3.60 billion in fiscal 2004. Fixed income revenues decreased 2.4%
to $3.00 billion for fiscal 2005 from $3.07 billion for fiscal 2004, primarily
attributable to a decrease in net revenues in the mortgage-backed securities
business, which was partially offset by an increase in net revenues in the
Company's leveraged finance and distressed debt areas. Mortgage-backed
securities origination revenues declined from the robust levels of fiscal 2004
due to a flattening yield curve, shifting market conditions and changes in
product mix. A decline in agency CMO volumes was offset by an increase in
non-agency
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
mortgage originations. Secondary mortgage-backed securities revenues also
declined from fiscal 2004 as an increase in hedging costs, resulting from more
volatile market conditions, offset increased customer volumes. The net revenues
from leveraged finance increased as acquisition-related financing rose on
increased M&A activities and distressed debt revenues increased as credit
spreads tightened and customer activity increased. In addition, revenues from
credit and fixed income derivatives increased due to increased customer volume.
Revenues derived from the Company's equities activities increased 60.0% to
$837.7 million in fiscal 2005 from $523.6 million in fiscal 2004, primarily due
to increased revenues from the Company's equity derivatives as a result of
increased customer volume and principal gains of $75.6 million associated with
the Company's investment in the International Securities Exchange ("ISE"). In
addition, equity revenues from the Company's international equity sales and
trading business increased, which benefited from higher average daily trading
volumes and increased market share.
Investment banking revenues increased slightly to $1.04 billion in fiscal 2005
from $1.03 billion in fiscal 2004. Underwriting revenues increased 8.6% to
$470.9 million in fiscal 2005 from $433.4 million in fiscal 2004, primarily
resulting from higher levels of equity underwriting revenues that reflected
strengthening market conditions and increased new issue activity. Partially
offsetting these increases was a decline in high yield underwriting revenues on
lower new issue volumes. Advisory and other fees for fiscal 2005 increased 17.7%
to $412.7 million from $350.7 million for fiscal 2004 as M&A fees rose resulting
from an increase in completed M&A assignments during fiscal 2005. In addition,
mortgage servicing revenues increased during fiscal 2005, reflecting significant
growth in loan servicing volumes. Merchant banking revenues decreased 37.8% to
$153.6 million for fiscal 2005 from $246.9 million for fiscal 2004. Merchant
banking revenues include realized and unrealized investment gains and
performance fees on managed merchant banking funds. Fiscal 2004 includes
merchant banking gains of approximately $163 million related to the Company's
investment in New York & Company, Inc.
Net interest revenues (interest and dividends revenue less interest expense)
increased 36.3% to $965.4 million in fiscal 2005 from $708.3 million in fiscal
2004. The increase in net interest revenues was primarily attributable to higher
levels of customer interest-bearing balances and improved net interest margins.
Average customer margin debt balances increased 25.8% to $64.9 billion in fiscal
2005 from $51.6 billion in fiscal 2004. Average customer short balances
increased 10.6% to $84.4 billion in fiscal 2005 from $76.3 billion in fiscal
2004 and average securities borrowed balances decreased 3.3% to $59.4 billion in
fiscal 2005 from $61.4 billion in fiscal 2004.
Asset management and other revenues increased 24.0% to $371.7 million for fiscal
2005 from $299.9 million for fiscal 2004, primarily reflecting increased
performance fees on proprietary hedge fund products. Management fees also
increased during fiscal 2005 on higher levels of traditional assets under
management. PCS fees increased as well due to higher levels of fee-based assets.
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Non-Interest Expenses
The Company's non-interest expenses for the fiscal years ended November 30,
2006, 2005 and 2004 were as follows:
- -------------------------------------------------------------------------------------------------------------------------
% Increase (Decrease)
2006 2005 2004 2006/2005 2005/2004
- -------------------------------------------------------------------------------------------------------------------------
(in thousands)
- -------------------------------------------------------------------------------------------------------------------------
Employee compensation
and benefits $ 4,343,499 $ 3,553,216 $ 3,253,862 22.2% 9.2%
Floor brokerage, exchange
and clearance fees 226,882 221,553 230,652 2.4% (3.9%)
Communications and technology 478,780 401,673 369,176 19.2% 8.8%
Occupancy 197,756 167,825 141,916 17.8% 18.3%
Advertising and market
development 147,262 126,678 113,800 16.2% 11.3%
Professional fees 279,942 229,198 197,086 22.1% 16.3%
Other expenses 406,414 503,592 484,237 (19.3%) 4.0%
- -------------------------------------------------------------------------------------------------------------------------
Total non-interest expenses $ 6,080,535 $ 5,203,735 $ 4,790,729 16.8% 8.6%
=========================================================================================================================
Fiscal 2006 versus Fiscal 2005 Employee compensation and benefits includes the
cost of salaries, benefits and incentive compensation, including Capital
Accumulation Plan ("CAP Plan") units, restricted stock units and option awards.
Employee compensation and benefits increased 22.2% to $4.34 billion for fiscal
2006 from $3.55 billion for fiscal 2005, primarily due to higher discretionary
compensation associated with the increase in net revenues and increased
headcount. Employee compensation and benefits as a percentage of net revenues
was 47.1% for fiscal 2006, compared with 47.9% for fiscal 2005. Full-time
employees increased to 13,566 at November 30, 2006 from 11,843 at November 30,
2005.
Non-compensation expenses increased 5.2% to $1.74 billion for fiscal 2006 from
$1.65 billion for fiscal 2005. Non-compensation expenses as a percentage of net
revenues decreased to 18.8% for fiscal 2006, compared with 22.3% for fiscal
2005. The increase in non-compensation-related costs compared with fiscal 2005
was principally related to increased communications and technology costs,
professional fees, occupancy costs and advertising and market development costs.
Communications and technology costs increased 19.2% to $478.8 million in fiscal
2006 from $401.7 million in fiscal 2005 as increased headcount resulted in
higher voice and market data-related costs as well as information technology
consulting costs. Professional fees increased 22.1% to $279.9 million in fiscal
2006 from $229.2 million in fiscal 2005 attributable to higher levels of non-IT
consulting fees, employment agency fees, and temporary staff. Occupancy costs
increased 17.8% to $197.8 million for fiscal 2006 from $167.8 million for fiscal
2005, reflecting additional office space requirements and higher leasing costs
associated with the Company's headquarters building at 383 Madison Avenue in New
York City. Advertising and market development costs increased 16.2% to $147.3
million for fiscal 2006 from $126.7 million for fiscal 2005 primarily due to
higher levels of business promotion expenses. Other expenses decreased 19.3% to
$406.4 million in fiscal 2006 from $503.6 million in fiscal 2005, principally
due to a reduction in legal and litigation-related costs. Partially offsetting
this decrease was an increase in costs related to the CAP Plan. CAP Plan-related
costs increased to $154.0 million for fiscal 2006 from $144.0 million in fiscal
2005 due to a higher level of earnings. The Company achieved a pre-tax profit
margin of 34.1% for fiscal 2006, up from 29.8% for fiscal 2005.
The Company's effective tax rate increased to 34.73% for fiscal 2006, compared
with 33.75% for fiscal 2005, primarily due to an increase in the level of
earnings in fiscal 2006, as related to preference items.
Fiscal 2005 versus Fiscal 2004 Employee compensation and benefits includes the
cost of salaries, benefits and incentive compensation, including CAP Plan units,
restricted stock units and option awards. Employee compensation
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
and benefits increased 9.2% to $3.55 billion for fiscal 2005 from $3.25 billion
for fiscal 2004, primarily due to higher discretionary compensation associated
with the increase in net revenues and an increase in headcount. Employee
compensation and benefits as a percentage of net revenues was 47.9% for fiscal
2005, compared with 47.8% for fiscal 2004. Full-time employees increased to
11,843 at November 30, 2005 from 10,961 at November 30, 2004.
Non-compensation expenses increased 7.4% to $1.65 billion for fiscal 2005 from
$1.54 billion for fiscal 2004. Non-compensation expenses as a percentage of net
revenues decreased to 22.3% for fiscal 2005, compared with 22.6% for fiscal
2004. The increase in non-compensation-related costs compared with fiscal 2004
was principally related to increased communications and technology costs,
occupancy costs and professional fees. Communications and technology costs
increased 8.8% as increased headcount resulted in higher voice and market
data-related costs. Occupancy costs increased 18.3% to $167.8 million for fiscal
2005, reflecting additional office space requirements and higher leasing costs
associated with the Company's headquarters building at 383 Madison Avenue in New
York City. Professional fees increased 16.3% to $229.2 million in fiscal 2005
from $197.1 million in fiscal 2004, attributable to higher levels of legal fees,
temporary help and employment agency fees. Other expenses increased $19.4
million, or 4.0%, in fiscal 2005, principally due to an increase in
litigation-related costs. Partially offsetting these increases was a decrease in
costs related to the CAP Plan. CAP Plan-related costs decreased to $144.0
million for fiscal 2005 from $176.0 million in fiscal 2004 due to fewer CAP Plan
units outstanding. The Company achieved a pre-tax profit margin of 29.8% for
fiscal 2005, up slightly from 29.7% for fiscal 2004.
The Company's effective tax rate increased to 33.75% for fiscal 2005, compared
with 33.50% for fiscal 2004.
BUSINESS SEGMENTS
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments.
For the year ended November 30, 2006, the Company changed its presentation of
segments to allocate certain revenues (predominantly interest) as well as
certain corporate administrative expenses from "Other" to its three business
segments. Certain legal and CAP Plan costs continue to be included in "Other."
Management believes that these changes provide an improved representation of
each segment's contribution to net revenues and pre-tax income for which to
evaluate performance. These reclassifications were also made to prior year
amounts to conform to the current year's presentation and are reflected in the
following business segment discussion and in Note 19, "Segment and Geographic
Area Data," in Notes to Consolidated Financial Statements.
Capital Markets
- ------------------------------------------------------------------------------------------------------------------
% Increase (Decrease)
2006 2005 2004 2006/2005 2005/2004
- ------------------------------------------------------------------------------------------------------------------
(in thousands)
- ------------------------------------------------------------------------------------------------------------------
Net revenues
Institutional equities $ 1,961,769 $ 1,445,907 $ 1,087,819 35.7% 32.9%
Fixed income 4,189,879 3,293,044 3,147,261 27.2% 4.6%
Investment banking 1,169,505 983,044 1,070,048 19.0% (8.1%)
- ------------------------------------------------------------------------------------------------------------------
Total net revenues $ 7,321,153 $ 5,721,995 $ 5,305,128 27.9% 7.9%
Pre-tax income $ 2,800,506 $ 2,020,484 $ 1,914,917 38.6% 5.5%
- ------------------------------------------------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
The Capital Markets segment is comprised of the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates as a
single integrated unit that provides the sales, trading and origination effort
for various fixed income, equity and advisory products and services. Each of the
three businesses work in tandem to deliver these products and services to
institutional and corporate clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, over-the-counter equities,
equity derivatives, energy and commodity activities, risk and convertible
arbitrage and through a majority-owned joint venture, specialist activities on
the NYSE, American Stock Exchange ("AMEX") and ISE. Fixed income includes sales,
trading, origination and research provided to institutional clients across a
variety of products such as mortgage- and asset-backed securities, corporate and
government bonds, municipal bonds, high yield products, including bank and
bridge loans, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses the
Company's underwriting of equity, investment grade, municipal and high yield
debt products.
Fiscal 2006 versus Fiscal 2005 Net revenues for Capital Markets increased 27.9%
to $7.32 billion for fiscal 2006, compared with $5.72 billion for fiscal 2005.
Pre-tax income for Capital Markets increased to $2.80 billion for fiscal 2006
from $2.02 billion for fiscal 2005. Pre-tax profit margin was 38.3% for fiscal
2006, compared with 35.3% for fiscal 2005.
Institutional equities net revenues for fiscal 2006 increased 35.7% to $1.96
billion from $1.45 billion for fiscal 2005. Revenues from the Company's energy
and commodity activities increased, reflecting gains from the sale of certain
commodity assets and increased revenues from the Company's energy activities.
Equity derivatives revenues increased during fiscal 2006 to record levels
reflecting increased customer activity and favorable market conditions. Net
revenues from international institutional equities activities increased,
reflecting higher customer trading volumes and increased market share in both
the European and Asian equity markets. Risk arbitrage revenues also increased
during fiscal 2006 on higher announced M&A volumes and market share gains.
Fiscal 2006 also included gains on the Company's investment in the NYSE Group
Inc.
Fixed income net revenues increased 27.2% to $4.19 billion for fiscal 2006 from
$3.29 billion for fiscal 2005, primarily reflecting strong results from the
Company's mortgage-backed securities area as well as record net revenues from
the credit businesses. Mortgage-backed securities revenues increased during
fiscal 2006 when compared with fiscal 2005 on higher origination volumes from
asset-backed securities, ARMs, and commercial mortgage-backed securities, as
well as increased secondary trading revenues. Credit products net revenues
reached record levels, reflecting a significant increase in revenues from the
Company's leveraged finance, distressed trading and credit derivatives areas.
Leveraged finance revenues achieved record levels, reflecting the surge in
acquisition related financing activity associated with higher M&A volumes and
increased market share. Revenues from the Company's interest rate product
business declined during fiscal 2006 when compared with fiscal 2005, primarily
due to a decrease in interest rate derivatives and foreign exchange revenues.
Investment banking revenues increased 19.0% to $1.17 billion for fiscal 2006
from $983.0 million for fiscal 2005. Underwriting revenues increased 6.7% to
$567.6 million for fiscal 2006 from $532.0 million for fiscal 2005. Higher
levels of high yield and high grade underwriting activity during fiscal 2006
were partially offset by lower levels of equity underwriting activity. Advisory
and other fees for fiscal 2006 increased 64.7% to $489.9 million from $297.4
million for fiscal 2005, reflecting an increase in M&A fees resulting from a
significant increase in completed M&A assignments. Merchant banking revenues
include realized and unrealized investment gains and performance fees on managed
merchant banking funds. Merchant banking revenues decreased 27.1% to $112.0
million for fiscal 2006 from $153.6 million for fiscal 2005.
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Fiscal 2005 versus Fiscal 2004 Net revenues for Capital Markets increased 7.9%
to $5.72 billion for fiscal 2005, compared with $5.31 billion for fiscal 2004.
Pre-tax income for Capital Markets increased 5.5% to $2.02 billion for fiscal
2005 from $1.91 billion for fiscal 2004. Pre-tax profit margin was 35.3% for
fiscal 2005, compared with 36.1% for fiscal 2004.
Institutional equities net revenues for fiscal 2005 increased 32.9% to $1.45
billion from $1.09 billion for fiscal 2004. Net revenues from domestic and
international institutional equities activities increased, reflecting higher
customer trading volumes. Market share gains in Europe and improved Asian equity
markets contributed to an increase in net revenues from international equities
activities in fiscal 2005. Risk arbitrage revenues increased during fiscal 2005
on higher announced M&A volumes and market share gains. Equity derivatives
revenues also increased significantly during fiscal 2005, benefiting from
improved market conditions and increased customer activity. Fiscal 2005 also
includes principal gains of $63.3 million associated with the Company's
investment in the ISE. Partially offsetting these increases was a decline in net
revenues from NYSE specialist activities during fiscal 2005, reflecting lower
market volatility.
Fixed income net revenues increased 4.6% to $3.29 billion for fiscal 2005 from
$3.15 billion for fiscal 2004, primarily reflecting strong results from the
Company's high yield business, particularly the leveraged finance and distressed
debt areas. Credit derivatives net revenues increased during fiscal 2005 on
improved customer volumes together with market share gains. In addition, net
revenues from the Company's interest rate business increased significantly on
record foreign exchange net revenues. During fiscal 2005, the Company maintained
its industry-leading position in underwriting adjustable-rate mortgages and
non-conforming fixed-rate mortgages. Mortgage-backed securities revenues
declined from the robust levels of fiscal 2004 due to a flattening yield curve,
shifting market conditions and changes in product mix. Secondary mortgage-backed
securities revenues also declined from fiscal 2004 as an increase in hedging
costs resulting from volatile market conditions offset increased customer
volumes.
Investment banking revenues decreased 8.1% to $983.0 million for fiscal 2005
from $1.07 billion for fiscal 2004. Underwriting revenues increased 2.4% to
$532.0 million for fiscal 2005 from $519.7 million for fiscal 2004. Higher
levels of equity and municipal underwriting revenues during fiscal 2005 were
partially offset by lower levels of high yield underwriting revenues. Advisory
and other fees for fiscal 2005 decreased 2.0% to $297.4 million from $303.4
million for fiscal 2004. Merchant banking revenues decreased 37.8% to $153.6
million for fiscal 2005 from $246.9 million for fiscal 2004. Fiscal 2004
included merchant banking gains related to the Company's investment in New York
& Company, Inc.
Global Clearing Services
- -------------------------------------------------------------------------------------------------------
% Increase (Decrease)
2006 2005 2004 2006/2005 2005/2004
- -------------------------------------------------------------------------------------------------------
(in thousands)
- -------------------------------------------------------------------------------------------------------
Net revenues $ 1,076,997 $ 1,028,864 $ 894,333 4.7% 15.0%
Pre-tax income $ 464,519 $ 471,796 $ 349,922 (1.5%) 34.8%
- -------------------------------------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At November 30, 2006 and 2005, the Company held approximately $291.2
billion and $264.1 billion, respectively, in equity in Global Clearing Services
client accounts.
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Fiscal 2006 versus Fiscal 2005 Net revenues for Global Clearing Services
increased 4.7% to $1.08 billion for fiscal 2006 from $1.03 billion for fiscal
2005. Net interest revenues increased 9.1% to $802.6 million for fiscal 2006
from $735.8 million for fiscal 2005, primarily reflecting increased average
customer margin balances from prime brokerage clients. These results were
partially offset by a decline in commission and other revenues of 6.4% to $274.4
million for fiscal 2006 from $293.1 million for fiscal 2005, reflecting reduced
rates from prime brokerage and fully disclosed clients. Pre-tax income decreased
1.5% to $464.5 million for fiscal 2006 from $471.8 million for fiscal 2005.
Pre-tax profit margin was 43.1% for fiscal 2006, compared with 45.9% for fiscal
2005.
The following table presents the Company's interest-bearing balances for the
fiscal years ended November 30, 2006 and 2005:
- -----------------------------------------------------------------------------------------------------
2006 2005
- -----------------------------------------------------------------------------------------------------
(in billions)
- -----------------------------------------------------------------------------------------------------
Margin debt balances, average for period $ 68.4 $ 64.9
Margin debt balances, at period end 78.6 66.6
Customer short balances, average for period 82.6 84.4
Customer short balances, at period end 95.8 79.9
Securities borrowed, average for period 55.0 59.4
Securities borrowed, at period end 57.6 49.9
Free credit balances, average for period 32.8 29.7
Free credit balances, at period end 32.6 31.0
Equity held in client accounts 291.2 264.1
- -----------------------------------------------------------------------------------------------------
Fiscal 2005 versus Fiscal 2004 Net revenues for Global Clearing Services
increased 15.0% to $1.03 billion for fiscal 2005 from $894.3 million for fiscal
2004. Net interest revenues increased 29.4% to $735.8 million for fiscal 2005
from $568.5 million for fiscal 2004, primarily reflecting increased average
customer margin and short sale balances from prime brokerage and fully disclosed
clearance clients due to improving US equity market conditions. These results
were partially offset by a decline in commission and other revenues of 10.0% to
$293.1 million for fiscal 2005 from $325.8 million for fiscal 2004, reflecting
reduced trading volumes and rates from prime brokerage clients. Pre-tax income
increased 34.8% to $471.8 million for fiscal 2005 from $349.9 million for fiscal
2004, reflecting higher net revenues and stable expenses. Pre-tax profit margin
was 45.9% for fiscal 2005, compared with 39.1% for fiscal 2004.
Wealth Management % Increase (Decrease)
(in thousands) 2006 2005 2004 2006/2005 2005/2004
- -----------------------------------------------------------------------------------------------------------------------------
Net revenues
Private client services revenues $ 620,337 $ 546,534 $ 527,127 13.5% 3.7%
Revenue transferred to Capital Markets segment (98,083) (93,586) (84,880) 4.8% 10.3%
- -----------------------------------------------------------------------------------------------------------------------------
Private client services net revenues 522,254 452,948 442,247 15.3% 2.4%
Asset management 335,474 227,572 185,768 47.4% 22.5%
- -----------------------------------------------------------------------------------------------------------------------------
Total net revenues $ 857,728 $ 680,520 $ 628,015 26.0% 8.4%
Pre-tax income $ 69,160 $ 36,770 $ 62,344 88.1% (41.0%)
- -----------------------------------------------------------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Wealth Management segment is comprised of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level of
investment service, including access to the Company's resources and
professionals. At November 30, 2006, PCS had approximately 500 account
executives in its principal office, six regional offices and two international
offices. Asset management manages equity, fixed income
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
and alternative assets for corporate pension plans, public systems, endowments,
foundations, multi-employer plans, insurance companies, corporations, families
and high-net-worth individuals in the United States and abroad.
Fiscal 2006 versus Fiscal 2005 Net revenues for Wealth Management increased
26.0% to $857.7 million for fiscal 2006 from $680.5 million for fiscal 2005. PCS
revenues increased 15.3% to $522.3 million for fiscal 2006 from $452.9 million
for fiscal 2005, reflecting increased fee income attributable to the Company's
private client advisory services products as well as an increase in broker
productivity. Asset management revenues increased 47.4% to $335.5 million for
fiscal 2006 from $227.6 million for fiscal 2005, reflecting increased
performance fees on proprietary hedge fund products and increased management
fees on higher levels of traditional assets under management. Pre-tax income for
Wealth Management increased 88.1% to $69.2 million in fiscal 2006 from $36.8
million for fiscal 2005.
Assets under management were $52.5 billion at November 30, 2006, reflecting a
25.3% increase from $41.9 billion in assets under management at November 30,
2005. The increase in assets under management primarily reflects an increase in
traditional equity assets attributable to both market appreciation and net
inflows. Assets under management at November 30, 2006 include $7.8 billion of
assets from alternative investment products, a 23.8% increase from $6.3 billion
at November 30, 2005.
Fiscal 2005 versus Fiscal 2004 Net revenues for Wealth Management increased 8.4%
to $680.5 million for fiscal 2005 from $628.0 million for fiscal 2004. PCS
revenues increased 2.4% to $452.9 million for fiscal 2005 from $442.2 million
for fiscal 2004, reflecting increased net interest revenues associated with
higher margin balances and increased fee income attributable to higher levels of
fee-based assets as well as an increase in broker productivity. Asset management
revenues increased 22.5% to $227.6 million for fiscal 2005 from $185.8 million
for fiscal 2004, reflecting increased performance fees on proprietary hedge fund
products. Management fees also increased during fiscal 2005 on higher levels of
traditional assets under management. Pre-tax income for Wealth Management
decreased 41.0% to $36.8 million in fiscal 2005 from $62.3 million for fiscal
2004. The pre-tax income decrease relates to $22 million in non-recurring income
received from the sale of assets to Dreyfus in fiscal 2004 as well as increased
operating costs incurred during fiscal 2005.
Assets under management were $41.9 billion at November 30, 2005, reflecting a
10.8% increase from $37.8 billion in assets under management at November 30,
2004. The increase in assets under management reflects continued increases in
traditional equity assets attributable to market appreciation and net inflows.
Assets under management at November 30, 2005 include $6.3 billion of assets from
alternative investment products, a slight increase from $6.2 billion at November
30, 2004.
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
LIQUIDITY AND CAPITAL RESOURCES
Financial Leverage
- ------------------
Asset Composition
The Company's actual level of capital, capital requirements and thereby the
level of financial leverage, is a function of numerous variables, including
asset composition, rating agency/creditor perception, business prospects,
regulatory requirements, balance sheet liquidity, cost/availability of capital
and risk of loss. The Company consistently maintains a highly liquid balance
sheet, with the vast majority of the Company's assets consisting of cash,
marketable securities inventories and collateralized receivables arising from
customer-related and proprietary securities transactions.
Collateralized receivables consist of resale agreements secured predominantly by
US government and agency securities, customer margin loans and securities
borrowed, which are typically secured by marketable corporate debt and equity
securities. The nature of the Company's business as a securities dealer requires
it to carry significant levels of securities inventories to meet its customer
and proprietary trading needs. Additionally, the Company's role as a financial
intermediary for customer activities, which it conducts on a principal basis,
together with its customer-related activities in its clearance business, results
in significant levels of customer-related balances, including customer margin
debt, securities borrowed and reverse repurchase activity. The Company's total
assets and financial leverage can and do fluctuate, depending largely on
economic and market conditions, volume of activity and customer demand.
The Company's total assets at November 30, 2006 increased to $350.4 billion from
$287.3 billion at November 30, 2005. The increase was primarily attributable to
increases in financial instruments owned, assets of variable interest entities
and mortgage loan special purpose entities, securities received as collateral,
and securities borrowed, partially offset by a decrease in securities purchased
under agreements to resell. The Company's total capital base, which consists of
long-term debt, preferred equity issued by subsidiaries and total stockholders'
equity, increased to $66.7 billion at November 30, 2006 from $54.3 billion at
November 30, 2005. This change was primarily due to a net increase in long-term
debt and an increase in stockholders' equity primarily due to fiscal 2006
earnings.
The Company's total capital base as of November 30, 2006 and 2005 was as
follows:
2006 2005
- --------------------------------------------------------------------------------------------------------------------
(in millions)
- --------------------------------------------------------------------------------------------------------------------
Long-Term Borrowings:
Senior debt $ 53,307.4 $ 43,227.1
Subordinated debt(1) 1,262.5 262.5
- --------------------------------------------------------------------------------------------------------------------
Total Long-Term Borrowings $ 54,569.9 $ 43,489.6
Stockholders' Equity:
Preferred stockholders' equity $ 359.2 $ 372.3
Common stockholders' equity 11,770.2 10,419.1
- -------------------------------------------------------------------------------------------------------------------
Total Stockholders' Equity $ 12,129.4 $ 10,791.4
- -------------------------------------------------------------------------------------------------------------------
Total Capital $ 66,699.3 $ 54,281.0
===================================================================================================================
(1) Includes $1.0 billion in subordinated debt issued by the Company and $262.5
million in junior subordinated deferrable interest debentures ("Debentures")
issued by the Company and held by Bear Stearns Capital Trust III ("Capital Trust
III") at November 30, 2006 and $262.5 million in Debentures issued by the
Company and held by Capital Trust III at November 30, 2005. See Note 9,
"Long-Term Borrowings," and Note 10, "Preferred Stock," in the Notes to
Consolidated Financial Statements for further information.
The amount of long-term debt as well as total capital that the Company maintains
is driven by a number of factors, with particular focus on asset composition.
The Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
on- and off-balance-sheet risks (i.e., market, credit and liquidity) and
regulatory capital requirements. As such, the liquidity and risk characteristics
of assets being held are critical determinants of both total capital and the
equity portion thereof, thus significantly influencing the amount of leverage
that the Company can employ.
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at each quarter end are typically lower than would be
observed on an average basis. At the end of each quarter, the Company typically
uses excess cash to finance high-quality, highly liquid securities inventory
that otherwise would be funded via the repurchase agreement market. In addition,
the Company reduces its matched book repurchase and reverse repurchase
activities at quarter end. Finally, the Company may reduce the aggregate level
of inventories through ordinary course, open market activities in the most
liquid portions of the balance sheet, which are principally US government and
agency securities and agency mortgage pass-through securities. At November 30,
2006, total assets of $350.4 billion were approximately 0.5% higher than the
average of the month-end balances observed over the trailing 12-month period,
while total assets at November 30, 2005 were approximately 5.9% lower than the
average of the same time period in the prior year. Despite reduced total assets
at each quarter end, the Company's overall market, credit and liquidity risk
profile does not change materially, since the reduction in asset balances is
predominantly in highly liquid, short-term instruments that are financed on a
secured basis. This periodic reduction verifies the inherently liquid nature of
the balance sheet and provides consistency with respect to creditor
constituents' evaluation of the Company's financial condition.
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of a securities firm, such as the Company. Gross leverage equals total
assets divided by stockholders' equity, inclusive of preferred and trust
preferred equity. The Company views its trust preferred equity as a component of
its equity capital base given the equity-like characteristics of the securities.
The Company also receives rating agency equity credit for these securities. Net
adjusted leverage equals net adjusted assets divided by tangible equity capital,
which excludes goodwill and intangible assets from both the numerator and
denominator, as equity used to support goodwill and intangible assets is not
available to support the balance of the Company's net assets. With respect to a
comparative measure of financial risk and capital adequacy, the Company believes
that the low-risk nature of the items excluded in deriving net adjusted assets
(see table) renders net adjusted leverage as the relevant measure.
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
The following table presents total assets and net adjusted assets with the
resultant leverage ratios at November 30, 2006 and 2005:
2006 2005
- -------------------------------------------------------------------------------------
(in millions, except ratios)
- -------------------------------------------------------------------------------------
Total assets $ 350,433 $ 287,293
Deduct:
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 8,804 5,270
Securities purchased under agreements
to resell 38,838 42,648
Securities received as collateral 19,648 12,426
Securities borrowed 80,523 62,915
Receivables from customers 29,482 31,273
Assets of variable interest entities and
mortgage loan special purpose entities,
net 29,080 14,321
Goodwill & intangible assets 383 355
- ------------------------------------------------------------------------------------
Subtotal 143,675 118,085
- ------------------------------------------------------------------------------------
Add:
Financial instruments sold,
but not yet purchased 42,256 33,022
Deduct:
Derivative financial instruments sold,
but not yet purchased 11,865 10,975
- ------------------------------------------------------------------------------------
Net adjusted assets $ 174,066 140,132
====================================================================================
Stockholders' equity
Common equity $ 11,770 $ 10,419
Stock-based compensation(1) 816 -
Preferred stock 359 372
- ------------------------------------------------------------------------------------
Total adjusted stockholders' equity 12,945 10,791
- ------------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
- -------------------------------------------------------------------------------------
Subtotal - leverage equity 13,208 11,054
- -------------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 383 355
- -------------------------------------------------------------------------------------
Tangible equity capital $ 12,825 $ 10,699
=====================================================================================
Gross leverage 26.5x 26.0x
Net adjusted leverage 13.6x 13.1x
- -------------------------------------------------------------------------------------
(1) Represents stock-based compensation associated with fiscal 2006 awards that
was reflected in equity as of the grant date in December 2006, in accordance
with SFAS No. 123(R), "Share-based Payment." In previous years, stock-based
compensation granted in December was included in stockholders' equity at
November year end. Excluding this adjustment for stock-based compensation, gross
leverage and net adjusted leverage would be 28.3x and 14.5x, respectively.
Funding Strategy & Liquidity Risk Management
- --------------------------------------------
General Funding Strategy
Liquidity is extraordinarily important for financial services firms in general
and for securities firms such as the Company in particular, given their reliance
on market confidence. The Company's overall objective and general funding
strategy seeks to ensure liquidity and diversity of funding sources to meet the
Company's financing needs at all times and under all market environments. In
financing its balance sheet, the Company attempts to maximize its use of secured
funding where economically competitive. Short-term sources of cash consist
principally of collateralized borrowings, including repurchase transactions,
sell/buy arrangements, securities lending arrangements and customer free credit
balances. Short-term unsecured funding sources expose the Company to rollover
risk, as providers of credit are not obligated to refinance the instruments at
maturity. For this reason, the Company seeks to prudently manage its
47
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
reliance on short-term unsecured borrowings by maintaining an adequate total
capital base and extensive use of secured funding. In addition to this strategy,
the Company places emphasis on diversification by product, geography, maturity
and instrument in order to further ensure prudent, moderate usage of more
credit-sensitive, potentially less stable, funding. Short-term unsecured funding
sources include commercial paper, medium-term notes and bank borrowings, which
generally have maturities ranging from overnight to one year. The Company views
its secured funding as inherently less credit sensitive and therefore a more
stable source of funding due to the collateralized nature of the borrowing.
In addition to short-term funding sources, the Company utilizes equity and
long-term debt, including floating- and fixed-rate notes, as longer-term sources
of unsecured financing. The Company regularly monitors and analyzes the size,
composition and liquidity characteristics of its asset base in the context of
each asset's ability to be used to obtain secured financing. This analysis helps
the Company in determining its aggregate need for longer-term funding sources
(i.e., long-term debt and equity). The Company views long-term debt as a stable
source of funding, which effectively strengthens its overall liquidity profile
and mitigates liquidity risk.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective of this
strategy is to maintain sufficient cash capital (i.e., equity plus long-term
debt maturing in more than 12 months) and funding sources to enable the Company
to refinance short-term, unsecured borrowings with fully secured borrowings. As
such, the Company is not reliant upon nor does it contemplate forced balance
sheet reduction to endure a period of constrained funding availability. This
underlying approach is supported by maintenance of a formal contingency funding
plan, which includes a detailed delegation of authority and precise action steps
for managing an event-driven liquidity crisis. The plan identifies the crisis
management team, details an effective internal and external communication
strategy, and facilitates the greater information flow required to effect a
rapid and efficient transition to a secured funding environment.
As it relates to the alternative funding strategy discussed above, the Company
prepares an analysis that focuses on a 12-month time period and assumes that the
Company does not liquidate assets and cannot issue any new unsecured debt,
including commercial paper. Under these assumptions, the Company monitors its
cash position and the borrowing value of unencumbered, unhypothecated financial
instruments in relation to its unsecured debt maturing over the next 12 months,
striving to maintain the ratio of liquidity sources to maturing debt at 110% or
greater. Also within this strategy, the Company seeks to maintain cash capital
in excess of that portion of its assets that cannot be funded on a secured basis
(i.e., positive net cash capital). These two measures, liquidity ratio and net
cash capital, are complementary and constitute the core elements of the
Company's alternative funding strategy and, consequently, its approach to
funding and liquidity risk management.
The borrowing value advance rates used in the Company's liquidity ratio
calculation and the haircuts incorporated in the cash capital model are
symmetrical. These advance rates are considered readily available, even in a
stress environment. In the vast majority of circumstances/asset classes, advance
rates are derived from committed secured bank facilities, whereby a bank or
group of banks are contractually obligated to lend to the Company at a
pre-specified advance rate on specific types of collateral regardless of "market
environment." As such, the advance rates/haircuts in the alternative liquidity
models are typically worse than those the Company realizes in normalized repo
and secured lending markets. The advance rates in the liquidity ratio reflect
what can be reliably realized in a stressed liquidity environment. The haircuts
used in the cash capital model are consistent with the advance rates used in the
liquidity ratio in that the haircut is equal to one minus the advance rate.
As of November 30, 2006, the market value of unencumbered, unhypothecated
financial instruments owned by the Company was approximately $47.7 billion with
a borrowing value of $37.2 billion. The assets are primarily comprised of
mortgage- and asset-backed securities, investment grade municipal and corporate
bonds, US equities and residential
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
and commercial mortgage whole loans. The average advance rate on these different
asset types ranges from 51% to 95% and, as described above, is based
predominantly on committed, secured facilities that the Company and its
subsidiaries maintain in different regions globally. The liquidity ratio,
explained above, based solely on Company-owned securities, has averaged 125%
over the previous 12 months, including unused committed unsecured bank credit
and 119%, excluding the unsecured portion of the Company's $4.0 billion
committed revolving credit facility. On this same basis, the liquidity ratio was
131% as of November 30, 2006 and 125% excluding committed unsecured bank credit.
While The Bear Stearns Companies Inc. ("Parent Company") is the primary issuer
of unsecured debt in the marketplace, the collateral referred to in the
preceding paragraph is held in various subsidiaries, both regulated and
unregulated. A subsidiary's legal entity status and the Company's intercompany
funding structure may constrain liquidity available to the Parent Company, as
regulators may prevent the flow of funds and/or securities from a regulated
subsidiary to its parent company or other subsidiaries. In recognition of this
potential for liquidity to be trapped in subsidiaries, the Company maintains a
minimum of $5.0 billion of liquidity immediately accessible by the Parent
Company at all times. This liquidity reserve takes the form of cash deposits and
money market instruments that are held at the Parent Company and high-quality
collateral (corporate bonds, municipal bonds, equity securities) that is owned
by subsidiaries and explicitly pledged to and segregated for the benefit of the
Parent Company and maintained at a third-party custodian. For purposes of
calculating the aggregate value of the liquidity reserve, the contractually
obligated advance rates described herein are used to determine the borrowing
value of collateral pledged. In addition to this immediately available
liquidity, the Company monitors unrestricted liquidity available to the Parent
Company via the ability to monetize unencumbered assets held in unregulated and
regulated entities. As of November 30, 2006, approximately $33.8 billion of the
market value identified in the liquidity ratio data above was held in
unregulated entities and thus likely to be available to the Parent Company,
while an additional $4.0 billion market value had been pledged to the Parent
Company as collateral for inter-company borrowings and was thus readily
available. The remaining $9.9 billion market value of unencumbered securities
was held in regulated entities, a portion of which may not be available to
provide liquidity to the Parent Company.
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. For
purposes of broadly classifying the drivers of cash capital requirements, cash
capital usage can be delineated across two very broad categories as (1) firmwide
haircuts and (2) illiquid assets/long-term investments. More precisely, the
Company holds cash capital to support longer-term funding requirements,
including, but not limited to, the following:
o That portion of financial instruments owned that cannot be funded on
a secured basis (i.e., the haircuts);
o Margin loans and resale principal in excess of the borrowing value
of collateral received;
o Operational cash deposits required to support the regular activities
of the Company (e.g., exchange initial margin);
o Unfunded committed funding obligations, such as corporate loan
commitments;
o Less liquid and illiquid assets, such as goodwill and fixed assets;
o Uncollateralized funded loans and funded loans secured by illiquid
and/or non-rehypothecatable collateral;
o Merchant banking assets and other long-term investments; and
o Regulatory capital in excess of a regulated entity's cash capital
based longer-term funding requirements.
At November 30, 2006, the Company's net cash capital position was $519.4
million. Fluctuations in net cash capital are common and are a function of
variability in total assets, balance sheet composition and total capital. The
Company attempts to maintain cash capital sources in excess of
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
the aggregate longer-term funding requirements of the firm (i.e., positive net
cash capital). Over the 12 months of fiscal year 2006, the Company's total cash
capital requirement, cash capital intensity ratio (average haircut), and net
cash capital position have averaged $53.9 billion, 15.2% and $1.8 billion,
respectively.
In addition to the alternative funding measures above, the Company monitors the
maturity profile of its unsecured debt to minimize refinancing risk, maintains
relationships with a broad global base of debt investors and bank creditors,
establishes and adheres to strict short-term debt investor concentration limits,
and periodically tests its secured and unsecured committed credit facilities. An
important component of the Company's funding and liquidity risk management
efforts involves ongoing dialogues with a large number of creditor constituents.
Strong relationships with a diverse base of creditors and debt investors are
crucial to the Company's liquidity. The Company also maintains available sources
of short-term funding that exceed actual utilization, thus allowing it to endure
changes in investor appetite and credit capacity to hold the Company's debt
obligations.
With respect to the management of refinancing risk, the maturity profile of the
long-term debt portfolio of the Company is monitored on an ongoing basis and
structured within the context of two diversification guidelines. The Company has
a general guideline of no more than 20% of its long-term debt portfolio maturing
in any one year, as well as no more than 10% maturing in any one quarter over
the next five years. The Company continued to effectively meet these guidelines
at the end of fiscal 2006 as evidenced by the bar graphs below. As of November
30, 2006, the weighted average maturity of the Company's long-term debt was 4.4
years.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
YEARLY LONG-TERM DEBT MATURITY PROFILE
As of November 30, 2006
$ in Millions
11,000 |
10,000 |
9,000 |
8,000 |
7,000 | [GRAPHIC OMITTED - BAR CHART
6,000 | SHOWN BY TABULAR DATA BELOW]
5,000 |
4,000 |
3,000 |
2,000 |
1,000 |
0 |
------------------------------------------------------------------------
One Two Three Four Five Six Seven Eight Nine Ten & >
YEARS
One Two Three Four Five Six Seven Eight Nine Ten & >
Non-Extendibles 6,484 7,694 8,540 6,584 6,812 2,540 3,215 2,851 1,381 5,171
Extendibles 3,298
FIVE YEAR QUARTERLY LONG-TERM DEBT MATURITY PROFILE
$ in Millions
5,500 |
5,000 |
4,500 |
4,000 |
3,500 | [GRAPHIC OMITTED - BAR CHART SHOWN BY TABULAR DATA BELOW]
3,000 |
2,500 |
2,000 |
1,500 |
1,000 |
500 |
0 |
----------------------------------------------------------------------------------------------------------------------------
1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11
QUARTERS
--------------------------------------------
[_] Non-Extendibles [_] Extendibles(1)
--------------------------------------------
1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10
Non-Extendibles 2,402 1,027 1,477 1,578 2,159 2,599 1,819 1,117 1,979 2,073 1,470 3,018 2,260 470 1,856 1,998
Extendibles(1) 3,098 200
1Q11 2Q11 3Q11 4Q11
Non-Extendibles 2,908 794 1,746 1,364
Extendibles(1)
(1) Extendibles are debt instruments with an extendible maturity date and are
included in long-term debt at the earliest maturity date. Unless debt holders
instruct the Company to redeem their debt, the earliest maturity date of these
instruments is automatically extended. Based on past experience, the majority of
the Company's extendibles is expected to remain outstanding beyond their
earliest maturity date.
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Committed Credit Facilities
- ---------------------------
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent Company
and BSIL to borrow up to $2.0 billion of the Facility on an unsecured basis.
Secured borrowings can be collateralized by both investment-grade and
non-investment-grade financial instruments as the Facility provides for defined
advance rates on a wide range of financial instruments eligible to be pledged.
The Facility contains financial covenants, the most significant of which require
maintenance of specified levels of stockholders' equity of the Company and net
capital of BSSC. In February 2007, the Company renewed the Facility with similar
terms. The Facility now allows the Parent Company, BSIL, and Bear Stearns
International Trading Limited ("BSIT") to borrow up to $4.0 billion of the
Facility on an unsecured basis. The Facility terminates in February 2008, with
all loans outstanding at that date payable no later than February 2009. There
were no borrowings outstanding under the Facility at November 30, 2006.
The Company has a $1.50 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, BSIT and
BSB. The Repo Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the Company.
The Repo Facility terminates in August 2007, with all repos outstanding at that
date payable no later than August 2008. There were no borrowings outstanding
under the Repo Facility at November 30, 2006.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan Asian Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company and net capital of BSSC.
In December 2006, the Company renewed the Facility at a $350 million committed
level with substantially the same terms. The Pan Asian Facility terminates in
December 2007 with all loans outstanding at that date payable no later than
December 2008. There were no borrowings outstanding under the Pan Asian Facility
at November 30, 2006.
The Company has a $350 million committed revolving credit facility ("Tax Lien
Facility"), which permits borrowing on a secured basis by the Parent Company,
Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax Lien Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Tax Lien Facility
terminates in March 2007 with all loans outstanding at that date payable no
later than March 2008. There were no borrowings outstanding under the Tax Lien
Facility at November 30, 2006.
The Company also maintains a series of committed credit facilities, which permit
borrowing on a secured basis, to support liquidity needs for the financing of
investment-grade and non-investment-grade corporate loans, residential
mortgages, commercial mortgages, listed options and whole loans. The facilities
are expected to be drawn from time to time and expire at various dates, the
longest of such periods ending in fiscal 2007. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $4.5 billion. At November 30, 2006, the borrowings outstanding
under these committed credit facilities were $90.1 million.
Capital Resources
- -----------------
The Parent Company, operating as the centralized unsecured funding arm of the
Company, raises the vast majority of the Company's unsecured debt, including
both commercial paper and long-term debt. The Parent Company is thus the
"central bank" of the Company, where all capital is held and from which capital
is deployed. The Parent Company advances funds in the form of debt or equity to
subsidiaries to meet their operating funding needs and regulatory capital
requirements. In addition to the primary regulated subsidiaries, the Company
also conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited, Custodial Trust Company, Bear
Stearns Financial Products Inc., Bear Stearns Capital Markets Inc., Bear Stearns
Credit Products Inc., Bear Stearns Forex Inc., EMC
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Mortgage Corporation, Bear Stearns Commercial Mortgage, Inc. and Bear Hunter
Holdings LLC. In connection with all of the Company's operating activities, a
substantial portion of the Company's long-term borrowings and equity has been
used to fund investments in, and advances to, these subsidiaries, including
subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At November 30, 2006, the Parent Company's equity investment
in subsidiaries was $7.9 billion versus common stockholders' equity and
preferred equity of $11.8 billion and $359.2 million, respectively. As such, at
November 30, 2006, the ratio of the equity investment in subsidiaries to Parent
Company equity (equity double leverage) was approximately 0.67 based on common
equity and 0.65 including preferred equity. At November 30, 2005, these measures
were 0.69 based on common equity and 0.67 including preferred equity.
Additionally, all subordinated debt advances to regulated subsidiaries for use
as regulatory capital, which totaled $10.0 billion at the end of fiscal 2006,
are funded with long-term debt issued by the Company, having a remaining
maturity equal to or greater than the maturity of the subordinated debt advance.
The Company regularly monitors the nature and significance of assets or
activities conducted in all subsidiaries and attempts to fund such assets with
both capital and/or borrowings having a maturity profile and relative mix
consistent with the nature and self-funding ability of the assets being
financed. The funding mix also takes into account regulatory capital
requirements for regulated subsidiaries.
Long-term debt totaling $48.1 billion and $37.0 billion had remaining maturities
beyond one year at November 30, 2006 and November 30, 2005, respectively. The
Company accesses funding in a variety of markets in the United States, Europe
and Asia. The Company issues debt through syndicated US registered offerings,
US-registered and 144A medium-term note programs, other US and non-US bond and
note offerings and other methods. The Company's access to external sources of
financing, as well as the cost of that financing, is dependent on various
factors and could be adversely affected by a deterioration of the Company's
long- and short-term debt ratings, which are influenced by a number of factors.
These include, but are not limited to: material changes in operating margins;
earnings trends and volatility; the prudence of funding and liquidity management
practices; financial leverage on an absolute basis or relative to peers; the
composition of the balance sheet and/or capital structure; geographic and
business diversification; and the Company's market share and competitive
position in the business segments in which it operates. Material deterioration
in any one or a combination of these factors could result in a downgrade of the
Company's credit ratings, thus increasing the cost of and/or limiting the
availability of unsecured financing. Additionally, a reduction in the Company's
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of November 30,
2006, a downgrade by either Moody's Investors Service or Standard & Poor's in
the Company's long-term credit ratings to the level of A2 or A (i.e., one notch)
would have resulted in the Company being required to post $53.2 million in
additional collateral pursuant to contractual arrangements for outstanding
over-the-counter derivatives contracts. A downgrade to A3 or A- (i.e., two
notches) would have resulted in the Company being required to post an additional
$118.1 million in collateral.
At November 30, 2006, the Company's long-term/short-term debt ratings were as
follows:
Long-Term Rating Short-Term Rating
- -------------------------------------------------------------------------------
Dominion Bond Rating Service Limited A(high) R-1(middle)
Fitch Ratings A+ F1+
Japan Credit Rating Agency, Ltd AA NR
Moody's Investors Service A1 P-1
Rating and Investment Information, Inc. AA- NR
Standard & Poor's Ratings Services A+ A-1
- -------------------------------------------------------------------------------
NR - does not assign a short-term rating
In October 2006, Standard & Poor's Ratings Services ("S&P") upgraded The Bear
Stearns Companies Inc. long-term rating to A+. In a press release, S&P stated
that the rating change reflects the Company's relatively low profit
53
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
volatility, conservative management and cost flexibility, as well as long-term
improvements in its liquidity and risk management. In addition, in June 2006,
Japan Credit Rating Agency, Ltd. assigned a rating of AA with a "Stable" outlook
to the Company, while in August 2006, Rating and Investment Information, Inc.
upgraded the Company to AA- from A+ with a "Stable" outlook.
Stock Repurchase Program
- ------------------------
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions. On
December 12, 2005, the Board of Directors of the Company approved an amendment
to the Stock Repurchase Program ("Repurchase Program") to replenish the previous
authorizations to allow the Company to purchase up to $1.5 billion of common
stock in fiscal 2006 and beyond. During the fiscal year ended November 30, 2006,
the Company purchased under the current and prior authorizations a total of
9,440,880 shares at a cost of approximately $1.22 billion. Approximately $279.9
million was available to be purchased under the current authorization as of
November 30, 2006. On December 13, 2006, the Board of Directors of the Company
approved an amendment to the Repurchase Program to replenish the previous
authorization in order to allow the Company to purchase up to $2.0 billion of
common stock in fiscal 2007 and beyond. The Company expects to utilize the
repurchase authorization to offset the dilutive impact of annual share awards.
The Company may, depending on price and other factors, repurchase additional
shares in excess of that required for annual share awards.
During the fiscal year ended November 30, 2006, the Company also purchased a
total of 1,141,334 shares of its common stock at a total cost of $154.0 million
pursuant to a $200 million CAP Plan Earnings Purchase Authorization, which was
approved by the Compensation Committee of the Board of Directors of the Company
on November 30, 2005. On December 12, 2006, the Compensation Committee of the
Company approved an amendment to the CAP Plan Earnings Purchase Authorization to
replenish the previous authorization in order to allow the Company to purchase
up to $200 million of common stock in fiscal 2007.
Cash Flows
- ----------
Fiscal 2006 Cash and cash equivalents decreased $1.26 billion to $4.60 billion
at November 30, 2006 from $5.86 billion at November 30, 2005. Cash used in
operating activities was $19.22 billion, primarily attributable to increases in
financial instruments owned and securities borrowed, net of securities loaned,
partially offset by increases in financial instruments sold, but not yet
purchased, securities sold under agreements to repurchase, net of securities
purchased under agreements to resell and net payable to customers, which
occurred in the normal course of business as a result of changes in customer
needs, market conditions and trading strategies. Cash used in investing
activities of $180.7 million reflected purchases of property, equipment and
leasehold improvements. Cash provided by financing activities of $18.14 billion
reflected net proceeds from the issuance of long-term borrowings of $19.89
billion and net proceeds relating to short-term borrowings of $9.05 billion,
primarily to fund normal operating activities. This was partially offset by net
payments for the retirement/repurchase of long-term borrowings of $10.25
billion. Treasury stock purchases of $1.37 billion were made to provide for the
annual grant of CAP Plan units, restricted stock units and stock options and
other corporate purposes.
Fiscal 2005 Cash and cash equivalents increased $1.69 billion to $5.86 billion
at November 30, 2005 from $4.17 billion at November 30, 2004. Cash used in
operating activities was $14.44 billion, primarily attributable to an increase
in financial instruments owned and a decrease in net payables to customers,
partially offset by increases in securities sold under agreements to repurchase,
net of securities purchased under agreements to resell and financial instruments
sold, but not yet purchased and a decrease in securities borrowed, net of
securities loaned, which occurred in the normal course of business as a result
of changes in customer needs, market conditions and trading strategies. Cash
used in investing activities of $202.9 million reflected purchases of property,
equipment and leasehold improvements. Cash provided by financing activities of
$16.33 billion reflected net proceeds from the issuance of long-term borrowings
of
54
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
$16.00 billion and net proceeds relating to short-term borrowings of $7.80
billion, primarily to fund normal operating activities. This was partially
offset by net payments for the retirement/repurchase of long-term borrowings of
$7.27 billion. Treasury stock purchases of $869.6 million were made to provide
for the annual grant of CAP Plan units, restricted stock units and stock
options.
Fiscal 2004 Cash and cash equivalents increased $335.8 million to $4.17 billion
at November 30, 2004 from $3.84 billion at November 30, 2003. Cash used in
operating activities was $2.34 billion, primarily attributable to an increase in
financial instruments owned, partially offset by a decrease in securities
borrowed, net of securities loaned and cash and securities deposited with
clearing organizations or segregated in compliance with federal regulations,
which occurred in the normal course of business as a result of changes in
customer needs, market conditions and trading strategies. Cash used in investing
activities of $128.4 million reflected purchases of property, equipment and
leasehold improvements. Cash provided by financing activities of $2.81 billion
reflected net proceeds of $11.25 billion from issuances of long-term borrowings
used primarily to fund normal operating activities. This was partially offset by
repayments of $6.65 billion in long-term borrowings, and net payments of $1.18
billion relating to short-term borrowings and a $300 million redemption of
trust-issued preferred stock. Treasury stock purchases of $780.8 million were
made to provide for the annual grant of CAP Plan units, restricted stock units
and stock options.
Regulated Subsidiaries
- ----------------------
Effective December 1, 2005, the Company became regulated by the Securities and
Exchange Commission ("SEC") as a consolidated supervised entity ("CSE"). As a
CSE, the Company is subject to group-wide supervision and examination by the SEC
and is required to compute allowable capital and allowances for market, credit
and operational risk on a consolidated basis. As of November 30, 2006, the
Company was in compliance with the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. Effective December 1, 2005,
the SEC approved Bear Stearns' use of Appendix E of the Net Capital Rule, which
establishes alternative net capital requirements for broker-dealers that are
part of consolidated supervised entities. Appendix E allows Bear Stearns to
calculate net capital charges for market risk and derivatives-related credit
risk based on mathematical models, provided that Bear Stearns holds tentative
net capital in excess of $1 billion and net capital in excess of $500 million.
BSIL and BSIT, the Company's London-based broker-dealer subsidiaries, are
subject to the regulatory capital requirements of the United Kingdom's Financial
Services Authority. Additionally, BSB is subject to the regulatory capital
requirements of the Financial Regulator. Custodial Trust Company ("CTC"), a
Federal Deposit Insurance Corporation ("FDIC") insured New Jersey state
chartered bank, is subject to the regulatory capital requirements of the FDIC.
At November 30, 2006, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were in
compliance with their respective regulatory capital requirements. Certain other
subsidiaries are subject to various securities regulations and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. At November 30, 2006, these other subsidiaries
were in compliance with their applicable local capital adequacy requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 16, "Regulatory
Requirements," in the Notes to Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
- -----------------------------------------------
In connection with the Company's merchant banking activities, the Company has
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At November
30, 2006, the Company held investments with an aggregate recorded value of
approximately $822.4 million,
55
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
reflected in the Consolidated Statements of Financial Condition in "Other
Assets." At November 30, 2005, the Company held investments with an aggregate
recorded value of approximately $658.8 million. In addition to these various
direct and indirect principal investments, the Company has made commitments to
invest in private equity-related investments and partnerships (see the summary
table under "Commitments").
High Yield Positions
- --------------------
As part of its fixed income activities, the Company participates in the
underwriting and trading of non-investment-grade corporate debt securities and
non-investment-grade commercial and leveraged loans. The Company also invests
in, syndicates and trades in loans to below-investment-grade-rated companies
(collectively, "high yield positions"). Non-investment-grade debt securities
have been defined as non-investment-grade corporate debt and emerging market
debt rated BB+ or lower, or equivalent ratings recognized by credit rating
agencies. At November 30, 2006 and November 30, 2005, the Company held high
yield positions approximating $10.73 billion and $6.71 billion, respectively,
substantially all of which are in "Financial Instruments Owned" in the
Consolidated Statements of Financial Condition, and $605.4 million and $1.72
billion, respectively, reflected in "Financial Instruments Sold, But Not Yet
Purchased" in the Consolidated Statements of Financial Condition. Included in
the high yield positions are extensions of credit to highly leveraged companies.
At November 30, 2006 and 2005, the amount outstanding to highly leveraged
borrowers totaled $7.70 billion and $4.24 billion, respectively. The largest
industry concentration was the telecommunications industry, which approximated
22.8% and 17.2% of these highly leveraged borrowers' positions at November 30,
2006 and 2005, respectively. Additionally, the Company has lending commitments
with highly leveraged borrowers (see the summary table under "Commitments").
The Company's Risk Management Department and senior trading managers monitor
exposure to market and credit risk for high yield positions and establish limits
and concentrations of risk by individual issuer. High yield positions generally
involve greater risk than investment grade debt securities due to credit
considerations, liquidity of secondary trading markets and increased
vulnerability to changes in general economic conditions. The level of the
Company's high yield positions, and the impact of such activities on the
Company's results of operations, can fluctuate from period to period as a result
of customer demand, economic conditions and market considerations.
Contractual Obligations
- -----------------------
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At November 30, 2006, the
Company's contractual obligations by maturity, excluding derivative financial
instruments, were as follows:
Payments Due by Period
---------------------------------------------------
Fiscal Fiscal Fiscal
2007 2008-2009 2010-2011 Thereafter Total
- ------------------------------------------------------------------------------------------------------------------------
(in millions)
- ------------------------------------------------------------------------------------------------------------------------
Long-term borrowings(1)(2) $ 6,484 $ 19,532 $ 13,396 $ 15,158 $54,570
Future minimum operating lease payments(3)(4) $ 98 $ 204 $ 204 $ 597 $ 1,103
- ------------------------------------------------------------------------------------------------------------------------
(1) Amounts include fair value adjustments in accordance with SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," as well as
$262.5 million of junior subordinated deferrable interest debentures
("Debentures"). The Debentures will mature on May 15, 2031; however, the
Company, at its option, may redeem the Debentures beginning May 15, 2006.
The Debentures are reflected in the table at their contractual maturity
dates.
(2) Included in fiscal 2008-2009 are approximately $1.83 billion of
floating-rate notes that are redeemable prior to maturity at the option of
the noteholder. These notes contain certain provisions that effectively
enable noteholders to put these notes back to the Company and, therefore,
are reflected in the table at the date such notes first become redeemable.
The final maturity dates of these notes are during fiscal 2010 - 2011.
(3) Includes the Company's Headquarters at 383 Madison Avenue in New York
City.
(4) See Note 17, "Commitments and Contingencies," in the Notes to Consolidated
Financial Statements.
56
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Commitments
- -----------
The Company has commitments(1) under a variety of commercial arrangements. At
November 30, 2006, the Company's commitments associated with lending and
financing, private equity-related investments and partnerships, underwriting,
outstanding letters of credit and other commercial commitments summarized by
period of expiration were as follows:
Amount of Commitment Expiration Per Period
------------------------------------------------------------------------------------------
Commitments
Fiscal Fiscal Fiscal with no stated
2007 2008-2009 2010-2011 Thereafter maturity Total
- ------------------------------------------------------------------------------------------------------------------------------------
(in millions)
- ------------------------------------------------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade(2) $ 1,983 $ 348 $ 1,464 $ 30 $ - $ 3,825
Non-investment-grade(2) 541 214 954 333 - 2,042
Contingent commitments 16,789 - - - 688 17,477
Commitments to invest in
private equity-related
investments and partnerships(3) - - - - 788 788
Underwriting commitments 205 - - - - 205
Commercial and residential loans 4,163 21 44 - - 4,228
Letters of credit 4,500 15 35 - - 4,550
Other commercial commitments 49 47 - - - 96
- ------------------------------------------------------------------------------------------------------------------------------------
(1) See Note 17, "Commitments and Contingencies," in the Notes to Consolidated
Financial Statements.
(2) In order to mitigate the exposure to investment-grade and
non-investment-grade borrowings, the Company entered into credit default swaps
approximating $697.8 million and $88.8 million, respectively, in notional value,
at November 30, 2006.
(3) At November 30, 2006, commitments to invest in private equity-related
investments and partnerships aggregated $788.3 million. These commitments will
be funded, if called, through the end of the respective investment periods, the
longest of such periods ending in 2017.
OFF-BALANCE-SHEET ARRANGEMENTS
In the normal course of business, the Company enters into arrangements with
special purpose entities ("SPEs"), also known as variable interest entities
("VIEs"). SPEs are corporations, trusts or partnerships that are established for
a limited purpose. SPEs, by their nature, are generally not controlled by their
equity owners, as the establishing documents govern all material decisions. The
Company's primary involvement with SPEs relates to securitization transactions
in which transferred assets, including commercial and residential mortgages,
consumer receivables, securities and other financial assets are sold to an SPE
and repackaged into securities or similar beneficial interests. SPEs may also be
used to create securities with a unique risk profile desired by investors and as
a means of intermediating financial risk. The Company, in the normal course of
business, may establish SPEs, sell assets to SPEs, underwrite, distribute and
make a market in securities or other beneficial interests issued by SPEs,
transact derivatives with SPEs, own securities or other beneficial interests,
including residuals, in SPEs, and provide liquidity or other guarantees for
SPEs.
The Company follows Statement of Financial Accounting Standards ("SFAS") No.
140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities--a Replacement of FASB Statement No. 125," to
account for securitizations and other transfers of financial assets. In
accordance with SFAS No. 140, the Company accounts for transfers of financial
assets as sales provided that control has been relinquished. Control is deemed
to be relinquished only when all of the following conditions have been met: (1)
the assets have been isolated from the transferor, even in bankruptcy or other
receivership; (2) the transferee is a Qualifying Special Purpose Entity ("QSPE")
or has the right to pledge or exchange the assets received; and (3) the
transferor has not maintained effective control over the transferred assets.
Therefore, the Company derecognizes financial assets transferred in
securitizations, provided that such transfer meets all of these criteria. See
Note 5, "Transfers of Financial Assets and Liabilities," in the Notes to
Consolidated Financial Statements
57
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
for a more complete discussion of the Company's securitization activities.
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company adopted Financial
Accounting Standards Board ("FASB") Interpretation ("FIN") No. 46 (R),
"Consolidation of Variable Interest Entities," for its variable interests in
fiscal 2004. The Company consolidates those VIEs in which the Company is the
primary beneficiary. See Note 6, "Variable Interest Entities and Mortgage Loan
Special Purpose Entities," in the Notes to Consolidated Financial Statements for
a complete discussion of the consolidation of VIEs.
The majority of the SPEs that the Company sponsors or transacts with are QSPEs,
which the Company does not consolidate in accordance with this guidance. QSPEs
are entities that have no discretionary activities and may only passively hold
assets and distribute cash generated by the assets they hold. The Company
reflects the fair value of its interests in QSPEs on its balance sheet but does
not recognize the assets or liabilities of QSPEs. QSPEs are employed extensively
in the Company's mortgage-backed and asset-backed securitization businesses.
Certain other SPEs do not meet the requirements of a QSPE, because their
activities are not sufficiently limited or they have entered into certain
non-qualifying transactions. The Company follows the criteria in FIN No. 46 (R)
in determining whether it should consolidate such entities. These SPEs are
commonly employed in collateralized debt obligation transactions where portfolio
managers have the ability to buy and sell assets or in synthetic credit
transactions.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivatives,
leasing, securitization and other transactions. See Note 18, "Guarantees," in
the Notes to Consolidated Financial Statements for a complete discussion on
guarantees.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into hedging
transactions that may include over-the-counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to hedge proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and US Treasury positions to hedge its
debt issuances as part of its asset and liability management.
In connection with the Company's dealer activities, the Company formed BSFP and
its wholly owned subsidiary, Bear Stearns Trading Risk Management Inc.
("BSTRM"). BSFP is a wholly owned subsidiary of the Company. BSFP and BSTRM were
established to provide clients with a AAA-rated counterparty that offers a wide
range of global derivative products. BSFP is structured so that if a specified
trigger
58
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
event (including certain credit rating downgrades of the Company, the failure of
BSFP to maintain its credit rating and the occurrence of a bankruptcy event with
respect to the Company) occurs, BSFP will perform on all of its contracts to
their original maturities with the assistance of an independent derivatives
portfolio manager who would assume the active management of BSFP's portfolio.
BSTRM is structured so that, on the occurrence of a specified trigger event, it
will cash-settle all outstanding derivative contracts in a predetermined manner.
Clients can use either structure. The AAA/Aaa ratings that BSFP and BSTRM have
received are based on their ability to meet their respective obligations without
any additional capital from the Company. In the unlikely occurrence of a trigger
event, the Company does not expect any significant incremental impact on the
liquidity or financial condition of the Company. At November 30, 2006, there was
no net potential cash settlement payable by BSTRM on the occurrence of a trigger
event.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not actually paid or received, with the exception
of currency swaps, foreign exchange forwards and mortgage-backed securities
forwards. The notional/contract amounts of financial instruments that give rise
to off-balance-sheet market risk are indicative only to the extent of
involvement in the particular class of financial instruments and are not
necessarily an indication of overall market risk.
As of November 30, 2006 and 2005, the Company had notional/contract amounts of
approximately $8.74 trillion and $5.45 trillion, respectively, of derivative
financial instruments, of which $1.25 trillion and $1.13 trillion, respectively,
were listed futures and option contracts. The aggregate notional/contract value
of derivative contracts is a reflection of the level of activity and does not
represent the amounts that are recorded in the Consolidated Statements of
Financial Condition. The Company's derivative financial instruments outstanding,
which are either used to hedge trading positions, modify the interest rate
characteristics of its long- and short-term debt, or form part of its derivative
dealer activities, are recorded in the Consolidated Statements of Financial
Condition at fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.1 years at November 30, 2006 and 2005. The maturities of
notional/contract amounts outstanding for derivative financial instruments as of
November 30, 2006 were as follows:
Less Than One to Three Three to Five Greater Than
One Year Years Years Five Years Total
- ---------------------------------------------------------------------------------------------------------------------------
(in billions)
- ----------------------------------------------------------------------------------------------------------------------------
Swap agreements, including options,
swaptions, caps, collars and floors $ 2,076.7 $ 1,656.0 $ 1,549.9 $ 2,005.9 $ 7,288.5
Futures contracts 457.5 290.3 24.6 0.2 772.6
Forward contracts 133.5 - - - 133.5
Options held 309.7 25.8 1.9 0.6 338.0
Options written 177.2 24.5 2.4 0.7 204.8
- ---------------------------------------------------------------------------------------------------------------------------
Total $ 3,154.6 $ 1,996.6 $ 1,578.8 $ 2,007.4 $ 8,737.4
===========================================================================================================================
Percent of total 36.1% 22.9% 18.1% 22.9% 100.0%
===========================================================================================================================
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements of the Company are prepared in conformity
with accounting principles generally accepted in the United States of America.
These principles require management to make certain estimates and assumptions
that could materially affect reported amounts in the financial statements (see
Note 1, "Summary of Significant Accounting Policies," in the Notes to
Consolidated Financial Statements). Critical accounting policies are those
policies that are the most important to the financial statements and/or those
that require significant management judgment related to matters that are
uncertain.
59
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex nature of certain of its products, the
degree of judgment required to appropriately value these products and the
pervasive impact of such valuation on the financial condition and earnings of
the Company.
The Company's financial instruments can be aggregated in three broad categories:
(1) those whose fair value is based on quoted market prices or for which the
Company has independent external valuations, (2) those whose fair value is
determined based on internally developed models or methodologies that employ
data that are readily observable from objective sources and (3) those whose fair
value is estimated based on internally developed models or methodologies
utilizing significant assumptions or other data that are generally less readily
observable from objective sources.
(1) Financial Instruments Valued Based on Quoted Market Prices or for Which the
Company Has Independent External Valuations
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include US Treasuries, most
mortgage-backed securities and corporate, emerging market, high yield and
municipal bonds. Unlike most equities, which tend to be traded on exchanges, the
vast majority of fixed income trading (including US Treasuries) occurs in
over-the-counter markets, and, accordingly, the Company's valuation policy is
based on its best estimate of the prices at which these financial instruments
trade in those markets. The Company is an active dealer in most of the
over-the-counter markets for these financial instruments, and typically has
considerable insight into the trading level of financial instruments held in
inventory and/or related financial instruments that it uses as a basis for its
valuation.
(2) Financial Instruments Whose Fair Value Is Determined Based on Internally
Developed Models or Methodologies That Employ Data That Are Readily Observable
from Objective Sources
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all of
these assumptions are observable in the marketplace, can be derived from
observable data, or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
the appropriate models or methodologies as well as the appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
non-exchange-traded derivatives such as interest rate swaps, certain
mortgage-backed securities and certain other cash instruments. For an indication
of the Company's involvement in derivatives, including maturity terms, see the
table setting forth notional/contract amounts outstanding in the preceding
"Derivative Financial Instruments" section.
(3) Financial Instruments Whose Fair Value Is Estimated Based on Internally
Developed Models or Methodologies Utilizing Significant Assumptions or Other
Data That Are Generally Less Readily Observable from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore require considerable judgment by traders and their management who, as
dealers in many of these instruments,
60
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
have the appropriate knowledge to estimate data inputs that are less readily
observable. For certain instruments, extrapolation or other methods are applied
to observed market or other data to estimate assumptions that are not
observable.
The Company followed Emerging Issues Task Force ("EITF") Statement No. 02-3,
"Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities," through November 30, 2006. This guidance generally eliminates the
practice of recognizing profit at the inception of a derivative contract unless
the fair value of the derivative is obtained from a quoted market price in an
active market or is otherwise evidenced by comparison to other observable
current market transactions or based on a valuation technique that incorporates
observable market data. The Company intends to adopt SFAS No. 157, "Fair Value
Measurements," in the first quarter of 2007. SFAS No. 157 nullifies the
consensus reached in EITF No. 02-3, which prohibited recognition of day one
gains or losses on certain derivative contracts. See Accounting and Reporting
Developments within Management's Discussion and Analysis for a complete
discussion of SFAS No. 157.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, real estate assets and certain
residuals. In addition, the Company has a portfolio of Chapter 13 and other
credit card receivables from individuals. Certain of these high yield positions
have limited price observability. In these instances, fair values are determined
by statistical analysis of historical cash flows, default probabilities,
recovery rates, time value of money and discount rates considered appropriate
given the level of risk in the instrument and associated investor yield
requirements.
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other exotic
derivative structures. These non-exchange-traded instruments may have immature
or limited markets and, by their nature, involve complex valuation methodologies
and models, which are often refined to correlate with the market risk of these
instruments.
At November 30, 2006 and 2005, the total value of all financial instruments
whose fair value is estimated based on internally developed models or
methodologies utilizing significant assumptions or other data that are generally
less readily observable from objective sources (primarily fixed income cash
positions) aggregated approximately $12.1 billion and $7.1 billion,
respectively, in "Financial Instruments Owned" and $7.5 billion and $3.5
billion, respectively, in "Financial Instruments Sold, But Not Yet Purchased" in
the Consolidated Statements of Financial Condition.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market ("MTM") Committee, which is composed of senior management
from the Risk Management and Controllers Departments. The MTM Committee is
responsible for ensuring that the approaches used to independently validate the
Company's valuations are robust, comprehensive and effective. Typical approaches
include valuation comparisons with external sources, comparisons with observed
trading, independent comparisons of key model valuation inputs, independent
trade modeling and a variety of other techniques.
61
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments in leveraged transactions. As part of these
activities, the Company originates, structures and invests in merger,
acquisition, restructuring and leveraged capital transactions, including
leveraged buyouts. The Company's principal investments in these transactions are
generally made in the form of equity investments, equity-related investments or
subordinated loans and have not historically required significant levels of
capital investment.
Equity interests and securities acquired as a result of leveraged acquisition
transactions are reflected in the consolidated financial statements at their
initial cost until significant transactions or developments indicate that a
change in the carrying value of the securities is appropriate. Generally, the
carrying values of these securities will be increased only in those instances
where market values are readily ascertainable by reference to substantial
transactions occurring in the marketplace or quoted market prices. If quoted
market prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined based on
other relevant factors. Reductions to the carrying value of these securities are
made in the event that the Company's estimate of net realizable value has
declined below the carrying value. See "Merchant Banking and Private Equity
Investments" in Management's Discussion and Analysis for additional details.
Legal, Regulatory and Tax Contingencies
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements, fines,
penalties, injunctions or other relief.
Reserves for litigation and regulatory proceedings are determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, the ultimate resolution, the timing of resolution or
the amount of eventual settlement, fine, penalty or relief, if any.
The Company is subject to the income tax laws of the United States, its states
and municipalities and those of the foreign jurisdictions in which the Company
has significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items affect taxable income in the various tax jurisdictions. Disputes over
interpretations of the tax laws may be settled with the taxing authority upon
examination or audit. The Company regularly evaluates the likelihood of
assessments in each of the taxing jurisdictions resulting from current and
subsequent years' examinations and tax reserves are established as appropriate.
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings and tax audits to the extent that such losses
are probable and can be estimated, in accordance with SFAS No. 5, "Accounting
for Contingencies." Once established, reserves are adjusted as additional
information becomes available or when an event requiring a change to the
reserves occurs. Significant judgment is required in making these estimates and
the ultimate resolution may differ materially from the amounts reserved.
62
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
ACCOUNTING AND REPORTING DEVELOPMENTS
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5, "Determining
Whether a General Partner, or the General Partners as a Group, Controls a
Limited Partnership or Similar Entity When the Limited Partners Have Certain
Rights." The EITF consensus requires a general partner in a limited partnership
to consolidate the limited partnership unless the presumption of control is
overcome. The general partner may overcome this presumption of control and not
consolidate the entity if the limited partners have: (a) the substantive ability
to dissolve or liquidate the limited partnership or otherwise remove the general
partner without having to show cause; or (b) substantive participating rights in
managing the partnership. This guidance became effective upon ratification by
the FASB on June 29, 2005 for all newly formed limited partnerships and for
existing limited partnerships for which the partnership agreements have been
modified. For all other limited partnerships, the guidance is effective no later
than the beginning of the first reporting period in fiscal years beginning after
December 15, 2005. As of December 1, 2006, the Company has fully adopted EITF
No. 04-5 for both newly formed partnerships as well as partnerships entered into
prior to June 29, 2005. The adoption of EITF No. 04-5 did not have a material
impact on the consolidated financial statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments an amendment of FASB Statements No. 133 and 140." SFAS No.
155 permits companies to elect, on a transaction-by-transaction basis, to apply
a fair value measurement to hybrid financial instruments that contain an
embedded derivative that would otherwise require bifurcation under SFAS No. 133.
As permitted, the Company adopted SFAS No. 155 on December 1, 2006 and elected
to apply a fair value measurement to all existing hybrid financial instruments
that meet the SFAS No. 155 definition. The Company has also elected the fair
value measurement for all appropriate hybrid financial instruments issued on or
after December 1, 2006. The adoption of SFAS No. 155 did not have a material
impact on the consolidated financial statements of the Company.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets--an amendment of FASB Statement No. 140." SFAS No. 156,
consistent with SFAS No. 140, requires that all separately recognized servicing
assets and liabilities be initially measured at fair value. For subsequent
measurements, SFAS No. 156 permits companies to choose between using an
amortization method or a fair value measurement method for reporting purposes.
SFAS No. 156 is effective as of the beginning of a company's first fiscal year
that begins after September 15, 2006. On December 1, 2006, the Company adopted
SFAS No. 156 and elected to measure servicing assets at fair value. The adoption
of this standard did not have a material impact on the consolidated financial
statements of the Company.
In April 2006, the FASB issued FASB Staff Position ("FSP") FIN No. 46 (R)-6,
"Determining the Variability to Be Considered in Applying Interpretation No. 46
(R)." This FSP addresses how a reporting enterprise should determine the
variability to be considered in applying FIN No. 46 (R). The variability that is
considered in applying FIN No. 46 (R) affects the determination of: (a) whether
the entity is a variable interest entity, (b) which interests are variable
interests in the entity, and (c) which party, if any, is the primary beneficiary
of the VIE. FSP FIN No. 46 (R)-6 states that the design of the entity shall be
considered in the determination of variable interests. The Company adopted FSP
FIN No. 46 (R)-6 on September 1, 2006. The adoption of this standard did not
have a material impact on the consolidated financial statements of the Company.
In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes--an interpretation of FASB Statement No. 109" ("FIN No. 48").
FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized
in an enterprise's financial statements in accordance with SFAS No. 109. FIN No.
48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN No. 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. The Company expects to adopt the provisions
of FIN No. 48 beginning in the first quarter of 2008. The Company is currently
evaluating the impact, if any, the adoption of FIN No. 48 may have on the
consolidated financial statements of the Company.
63
MANAGEMENT'S DISCUSSION AND ANALYSIS
continued
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." SFAS
No. 157 defines fair value, establishes a framework for measuring fair value and
requires enhanced disclosures about fair value measurements. SFAS No. 157
requires companies to disclose the fair value of its financial instruments
according to a fair value hierarchy. The fair value hierarchy ranks the quality
and reliability of the information used to determine fair values. Financial
assets carried at fair value will be classified and disclosed in one of the
three categories in accordance with the hierarchy. The three levels of the fair
value hierarchy are:
o Level 1: Quoted market prices for identical assets or liabilities in
active markets.
o Level 2: Observable market-based inputs or unobservable inputs that
are corroborated by market data.
o Level 3: Unobservable inputs that are not corroborated by market
data.
Additionally, companies are required to provide enhanced disclosure information
regarding the activities of those financial instruments classified within the
level 3 category, including a rollforward analysis of fair value balance sheet
amounts for each major category of assets and liabilities and disclosure of the
unrealized gains and losses for level 3 positions held at the reporting date.
SFAS No. 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007. Early adoption is permitted if the entity has
not yet issued financial statements for that fiscal year (including any interim
periods). The Company is planning to early adopt SFAS No. 157 in the first
quarter of fiscal 2007 as permitted, and does not expect that the adoption of
SFAS No. 157 will have a material impact on the consolidated financial
statements of the Company.
EFFECTS OF INFLATION
The Company's assets are primarily recorded at their current market value and,
to a large extent, are liquid in nature. The rate of inflation affects the
Company's expenses, such as employee compensation, office leasing costs,
information technology and communications charges, which may not be readily
recoverable in the price of services offered by the Company. In addition, to the
extent that inflation causes interest rates to rise and has other adverse
effects on the securities markets and on the value of securities held in
inventory, it may adversely affect the Company's financial position and results
of operations.
64
THE BEAR STEARNS COMPANIES INC.
RISK MANAGEMENT
OVERALL
The Company's principal business activities engender significant market and
credit risks. In addition, the Company is subject to operational, legal, funding
and other risks. Effective identification, assessment and management of these
risks are critical to the success and stability of the Company. As a result,
comprehensive risk management procedures have been established to identify,
monitor and control each of these major risks. The risk management process
encompasses many units independent of the trading desks, including the Risk
Management, Global Credit, Global Clearing Services, Controllers, Operations,
Compliance, Legal and Financial Analytics & Structured Transactions ("F.A.S.T.")
Departments. The Company's diverse securities industry activities help to reduce
the impact that volatility in any particular market may have on its net
revenues. The Treasurer's Department is independent of trading units and is
responsible for the Company's funding and liquidity risk management. Funding and
liquidity risk management are discussed in Management's Discussion and Analysis
of Financial Condition and Results of Operations in the "Liquidity and Capital
Resources" section.
The Company has established various management committees that have
responsibilities for monitoring and oversight of its activities and risk
exposures. Some of these committees are described below.
The Executive Committee is the most senior management committee of the Company.
The ultimate approval of decisions regarding the Company's risk appetite and
risk-taking capacity rests with the Executive Committee.
The Management & Compensation Committee has primary responsibility for hiring
approvals and compensation-related issues. In addition, a number of decisions
regarding business risk and other issues are delegated to the Management &
Compensation Committee from the Executive Committee.
The Operations Committee is composed of senior managing directors from various
departments, primarily representing key internal control functions. The
Operations Committee ensures the coordination of key operational, control and
regulatory issues across the Company.
The Risk Committee is composed of senior managing directors from each trading
department as well as the Risk Management Department. The Risk Committee
provides a high level of oversight to trading departments and their trading
strategies.
The Credit Policy Committee is composed of senior risk, legal and business
managers. The Credit Policy Committee delegates credit approval authority to the
Global Credit Committee, approves exposure measurement standards, reviews
concentrations of credit risk, sets documentation and credit support standards,
and considers new or unusual credit-related transactions.
The Global Credit Committee, which includes several members of the Credit Policy
Committee, implements policy through its review and approval of counterparty
credit limits.
The Model Review Committee is composed of senior members of the Risk Management,
Risk Analytics and F.A.S.T. Departments, as well as senior business unit
managers who have experience developing and using trading models. The Model
Review Committee works with staff of the Risk Management Department to ensure
that trading models are independently vetted and controlled.
The Principal Activities Committee is composed of senior investment banking,
capital markets, credit and risk management professionals. The Principal
Activities Committee reviews and approves loan underwriting proposals. Certain
leveraged loan commitments, as well as large or unusual credit extensions, are
referred by this committee for approval to the Company's Executive Committee.
65
RISK MANAGEMENT
continued
The Mark-to-Market (MTM) Committee is composed of senior management from the
Risk Management and Controllers Departments. The MTM Committee is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective.
The New Products and Special Structured Transactions Committee is composed of
senior management from various departments. The New Products and Special
Structured Transactions Committee is responsible for ensuring that identified
new businesses and products are reviewed in advance for legal, credit,
operational, accounting, market and reputation risk and related concerns. The
New Products and Special Structured Transactions Committee meets on a regular
basis to review new business proposals and address related issues.
The Disclosure Committee is composed of senior members of management, including
the chief financial officer, controller and general counsel. The Disclosure
Committee has oversight responsibilities for assisting in the review of
disclosures to be made by the Company to help ensure that they are complete and
accurate, fairly represent the Company's financial condition and are in
compliance with the requirements of applicable securities laws, rules and
regulations of the NYSE.
The Company's Ethics Compliance Committee is composed of the Company's ethics
compliance officer and senior management from various departments, including
Administration, Legal and Compliance. The Ethics Compliance Committee is
responsible for administering and enforcing the Company's Code of Business
Conduct and Ethics and ethics-related standards and procedures adopted by the
Corporate Governance Committee. The Ethics Compliance Committee also evaluates
potential conflicts of interest between the Company and its officers.
MARKET RISK
Market risk generally represents the risk of loss that may result from the
potential change in the value of a financial instrument as a result of
fluctuations in interest and currency exchange rates, equity, futures and
commodity prices, changes in the implied volatility of interest rates, foreign
exchange rates, equity, futures and commodity prices, and price deterioration or
changes in value due to changes in market perception or actual credit quality of
either the issuer or its country of origin. Market risk can be exacerbated in
times of illiquidity where market participants refrain from transacting in
normal quantities and/or at normal bid-offer spreads. Market risk is inherent to
both cash and derivative financial instruments and, accordingly, the scope of
the Company's market risk management procedures includes all market
risk-sensitive financial instruments. The Company's exposure to market risk is
directly related to its role as a financial intermediary in customer trading
transactions and to its proprietary trading, investment and arbitrage
activities.
The Company makes dealer markets in investment grade, corporate debt,
non-investment-grade corporate ("high yield") debt, US government securities,
sovereign debt, emerging markets debt obligations, mortgages and mortgage-backed
securities, other collateralized securities and municipal bonds. The Company is
also an active market maker and conducts block trading activities in both listed
and over-the-counter equity markets. In connection with these activities, the
Company may be required to maintain significant inventories to ensure
availability and to facilitate customer order flow. The Company is also engaged
as a dealer in both listed and over-the-counter derivatives and, accordingly,
enters into transactions such as interest rate and cross-currency swaps,
over-the-counter options on interest rates and foreign currencies, various
credit default swaps and equity swaps and options, all as part of its customer
and proprietary trading activities. In connection with these activities, the
Company attempts to mitigate its exposure to market risk by entering into
hedging transactions, which may include listed and over-the-counter derivatives
contracts or the purchase or sale of securities, financial futures and options
on futures or forward contracts. Additionally, the Company has a controlling
interest in a majority-owned joint venture that transacts in specialist
activities on the NYSE, AMEX and ISE. Stock exchange rules require that
specialists maintain an orderly market, including purchasing shares in a
declining market, which may result in trading losses.
66
RISK MANAGEMENT
continued
The Company's arbitrage activities are designed to take advantage of market
price discrepancies in securities trading in different markets, between related
products or derivative instruments. Arbitrage activities involve maintaining
offsetting positions in other financial instruments. In many instances, the
Company may be required to purchase or sell derivative financial instruments as
part of the arbitrage of a cash market security. These transactions may involve
forward-settling transactions such as forwards or futures, where the objective
may be to capture differences in the time value of money, or options
transactions, which seek to capture differences between the expected and actual
volatility of the underlying instrument. The Company attempts to mitigate market
risk in these activities by entering into hedging transactions.
Managing risk at the Company begins with the expertise and experience of trading
department management. Senior managing directors in each department have
extensive knowledge of the specialized products, markets and activities in which
they do business. Their experience and insight are supplemented by risk
management procedures that monitor and evaluate the Company's risk profile.
Those procedures begin with the Company marking its financial instruments owned
to fair value on a daily basis and producing daily profit and loss statements
for senior management covering all trading departments.
The cornerstone of these procedures is constant communication between trading
department management and senior management concerning inventory positions and
market risk profile. This process culminates each week with the trading
departments making formal reports of positions, profits and losses and certain
trading strategies to the Risk Committee.
The Company believes that a clear understanding of how its positions generate
profit or loss on a daily basis is crucial to managing risk. Many of the
independent units are actively involved in ensuring the integrity and clarity of
the daily profit and loss statements. Activities include daily and monthly price
verification procedures, position reconciliation, review of pricing models and
review of recording of complex transactions. Furthermore, the Company uses
market-based credit pricing to estimate the appropriate credit reserves
associated with certain counterparty credit exposures.
In addition, trading desk management, senior management and independent units
also review the age and composition of proprietary accounts and review risk
reports appropriate to the risk profile of each trading activity. Risk limits
are established and monitored, market conditions are evaluated, certain
transactions are reviewed in detail, and quantitative methods such as
value-at-risk and stress testing are employed (see "Value-at-Risk"). These
procedures better ensure that trading strategies are followed within acceptable
risk parameters.
The Risk Management Department is independent of all trading areas and reports
to the chief risk officer. The goals of the department are to understand the
market risk profile of each trading area, to consolidate common risks on a
firmwide basis, to articulate large trading or position risks to senior
management, to provide traders with perspectives on their positions and to
better ensure accurate mark-to-market pricing. The department supplements the
communication between trading managers and senior management by providing its
independent perspective on the Company's market risk profile via a daily risk
highlights report that is distributed to a number of senior managers in the
Company.
The Company is an active participant in over-the-counter markets, including
derivatives, commercial and residential mortgage loans, leveraged loans and
Chapter 13 and other credit card receivables. The nature of many of these
financial instruments is such that they are valued through the use of models.
The complexities and reduced transparency inherent in financial instruments that
are valued using models, as compared with exchange-traded prices or other quoted
market valuations, introduce a particular element of operational risk into the
Company's business. In most cases, internal valuation models are developed by
staff within the F.A.S.T. Department. Traders and trading management supplement
and review the development efforts. A further level of review is performed by
the independent model review team within the Risk Management Department. Results
of the independent model review process are presented to the Model
67
RISK MANAGEMENT
continued
Review Committee. In certain cases, the Company is also able to compare its
model-based valuations with counterparties in conjunction with collateral
exchange agreements. Senior trading managers and independent Risk Management
also emphasize the importance of two-way trading in financial instruments valued
using models in order to verify the accuracy of the models. While the Company
believes these controls to be effective, it is also important to note that the
risk of model-based valuations is inherent in a number of the Company's
activities.
Following is a discussion of the Company's primary market risk exposures as of
November 30, 2006 and November 30, 2005, including a discussion of how those
exposures are currently managed. The following discussion of the Company's risk
management procedures for its principal risks and the estimated amounts of the
Company's market risk exposure generated by the Company's statistical analyses
contains forward-looking statements. The analyses used to assess such risks are
not predictions of future events, and actual results may vary significantly from
such analyses due to events in the markets in which the Company operates and
certain other factors as described herein.
Interest Rate Risk
Interest rate risk is a consequence of maintaining market-making and proprietary
inventory positions and trading in interest rate-sensitive financial
instruments. In connection with the Company's dealer and arbitrage activities,
including market-making in over-the-counter derivatives contracts, the Company
exposes itself to interest rate risk arising from changes in the level or
volatility of interest rates, mortgage prepayment speeds or the level and shape
of the yield curve. The Company's fixed income activities also expose it to the
risk of loss related to changes in credit spreads on debt instruments. Credit
spread risk arises from the potential that changes in an issuer's credit rating
or credit perception could affect the value of financial instruments. Credit
risk resulting from default on counterparty obligations is discussed in the
"Credit Risk" section. The Company attempts to hedge its exposure to interest
rate risk primarily through the use of interest rate swaps, options, eurodollar
and US government securities, and futures and forward contracts designed to
reduce the Company's risk profile. Credit spread risk is hedged through the use
of credit derivatives such as credit default swaps, and by offsetting long or
short positions in various related securities.
Foreign Exchange Rate Risk
Foreign exchange rate risk arises from the possibility that changes in foreign
exchange rates will affect the value of financial instruments. When the Company
buys or sells a foreign currency or a financial instrument denominated in a
currency other than US dollars, exposure exists from a net open currency
position. Until the position is covered by selling or buying the equivalent
amount of the same currency or by entering into a financing arrangement
denominated in the same currency, the Company is exposed to the risk that the
exchange rate may move against it. The Company attempts to hedge the risk
arising from its foreign exchange activities primarily through the use of
currency borrowing, swaps, options, forwards and futures.
Equity Price Risk
The Company is exposed to equity price risk through making markets in equity
securities, distressed debt, equity derivatives as well as specialist
activities. Equity price risk results from changes in the level or volatility of
equity prices, which affect the value of equity securities or instruments that
derive their value from a particular stock, a basket of stocks or a stock index.
The Company attempts to reduce the risk of loss inherent in its inventory of
equity securities by entering into hedging transactions, including equity
options and futures, designed to mitigate the Company's market risk profile.
Commodity Price Risk
Beginning in fiscal 2006, the Company is exposed to commodity price risk.
Commodity price risk refers to the potential loss the Company could suffer from
adverse moves in the levels of commodity prices and derivatives linked to them.
The Company is exposed to such moves through its energy trading business, which
transacts in both listed and over-the-counter energy derivatives as well as the
underlying physical commodities themselves, and through various trading
activities which make use of listed commodity futures and options on futures.
The Company attempts to
68
RISK MANAGEMENT
continued
mitigate the risk of loss in these activities by using commodity derivatives to
limit its exposure to changes in the overall level of any given commodity price,
to changes in the volatility of that price, and to changes in the relative
levels of future prices for that commodity.
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models known
as value-at-risk ("VaR") that seek to predict risk of loss based on historical
and/or market-implied price and volatility patterns. VaR estimates the
probability of the value of a financial instrument rising above or falling below
a specified amount. The calculation uses the simulated changes in value of the
market risk-sensitive financial instruments to estimate the amount of change in
the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk
and commodity price risk), due to the benefit of diversification among the
risks. Diversification benefit equals the difference between aggregate VaR and
the sum of the VaRs for the four risk categories. This benefit arises because
the simulated one-day losses for each of the four primary market risk categories
occur on different days and because of general diversification benefits
introduced when risk is measured across a larger set of specific risk factors
than exist in the respective categories; similar diversification benefits also
are taken into account across risk factors within each category. The following
table illustrates the VaR for each component of market risk as of November 30,
2006 and 2005.
69
RISK MANAGEMENT
continued
2006 2005
- ---------------------------------------------------------------
(in millions)
- ---------------------------------------------------------------
MARKET RISK
Interest rate $ 29.9 $ 22.1
Currency 0.8 0.3
Equity 3.0 3.6
Commodity 0.0 0.0
Diversification benefit (4.9) (4.6)
- ---------------------------------------------------------------
Aggregate VaR $ 28.8 $ 21.4
===============================================================
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during fiscal 2006 and fiscal 2005
(calculated on a daily basis):
Fiscal 2006 Fiscal 2005
----------------------------------- --------------------------------------
High Low Average High Low Average
- --------------------------------------------------------- --------------------------------------
(in millions)
- --------------------------------------------------------- --------------------------------------
MARKET RISK
Interest rate $ 41.3 $ 20.3 $ 30.8 $ 30.6 $ 11.9 $ 22.1
Currency 3.2 0.0 0.8 3.4 0.0 1.2
Equity 11.3 1.3 4.3 5.3 0.7 2.9
Commodity 1.2 0.0 0.2 0.0 0.0 0.0
Aggregate VaR 44.4 19.0 28.6 31.4 11.9 20.5
- --------------------------------------------------------- --------------------------------------
Aggregate average VaR increased to $28.6 million in 2006 from $20.5 million in
2005. The increase was primarily due to higher levels of exposure to interest
rates and equity prices.
As previously discussed, the Company utilizes a wide variety of market risk
management methods, including trading limits; marking all positions to market on
a daily basis; daily profit and loss statements; position reports; daily risk
highlight reports; aged inventory position reports; and independent verification
of inventory pricing. Additionally, management of each trading department
reports positions, profits and losses and notable trading strategies to the Risk
Committee on a weekly basis. The Company believes that these procedures, which
stress timely communication between traders, trading department management and
senior management, are the most important elements of the risk management
process.
Stress testing (also referred to as scenario analysis) measures the risk of loss
over a variety of extreme market conditions that are defined in advance. Stress
testing is a key methodology used in the management of market risk as well as
counterparty credit risk (see "Credit Risk"). Stress tests are calculated at the
firmwide level for particular trading books, customer accounts and individual
positions. Stress tests are performed on a regular basis as well as on an ad hoc
basis, as deemed appropriate. The ongoing evaluation process of trading risks as
well as the consideration of new trading positions commonly incorporates an ad
hoc discussion of "what-if" stressed market conditions and their impact on
profitability. This analysis varies in its degree of formality based on the
judgment of trading department management, risk management and senior managers.
While the Company recognizes that no methodology can perfectly predict future
market conditions, it believes that these tools are an important supplement to
the Company's risk management process. The Company expects to continue to
develop and refine its formal stress testing methodologies.
70
RISK MANAGEMENT
continued
The following chart represents a summary of the daily principal transactions
revenues and reflects a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the fiscal years ended November
30, 2006 and 2005. The chart represents a historical summary of the results
generated by the Company's trading activities as opposed to the probability
approach used by the VaR model. The average daily trading profit was $19.8
million and $15.2 million for the fiscal years ended November 30, 2006 and 2005,
respectively. There were 13 daily trading losses for the fiscal year ended
November 30, 2006 and 9 daily trading losses for the fiscal year ended November
30, 2005. Daily trading losses never exceeded the reported average VaR amounts
during the fiscal years ended November 30, 2006 and 2005. The frequency
distribution of the Company's daily net trading revenues reflects the Company's
historical ability to manage its exposure to market risk and the diversified
nature of its trading activities. Market conditions were favorable for the
Company's trading activity in both its fiscal years ending November 30, 2006 and
2005. Hedging strategies were generally effective as established trading
relationships remained substantially intact and volatility tended to be lower
than historical norms. No guarantee can be given regarding future net trading
revenues or future earnings volatility. However, the Company believes that these
results are indicative of its commitment to the management of market trading
risk.
DISTRIBUTION OF DAILY NET TRADING REVENUES
FISCAL YEARS ENDED NOVEMBER 30, 2006 AND NOVEMBER 30, 2005
NUMBER 70 |
OF 60 |
TRADING 50 | [GRAPHIC OMITTED - BAR CHART SHOWN BY TABULAR DATA BELOW]
DAYS 40 |
30 |
20 |
10 |
0 |
-------------------------------------------------------------------
(10)+ (10)-(5) (5)-0 0-5 5-10 10-15 15-20 20-25 25-30 30+
DAILY NET TRADING REVENUES ($ in millions)
------------------
[_] 2006 [_] 2005
------------------
(10)+ (10)-(5) (5)-0 0-5 5-10 10-15 15-20 20-25 25-30 30+
[_] 2006 0 2 10 21 39 38 44 36 21 41
[_] 2005 1 4 4 27 38 59 58 33 14 14
71
RISK MANAGEMENT
continued
CREDIT RISK
Credit risk arises from potential non-performance by counterparties, customers,
borrowers or debt security issuers. The Company is exposed to credit risk as
trading counterparty to dealers and customers, as direct lender, as holder of
securities and as member of exchanges and clearing organizations. The Company
has established policies and procedures to manage credit risk.
Dedicated professionals in several departments contribute to the administration
of the Company's credit policies and procedures. The responsible groups include
Global Credit, Operations and Administration (Margin), Risk Management, Global
Clearing Services (Prime Brokerage) and Investment Banking.
The Global Credit Department monitors and controls extensions of credit to
customers and dealer counterparties and, in conjunction with the Credit Policy
Committee and its subcommittee, the Global Credit Committee, establishes and
reviews appropriate credit limits and collateral requirements for customers and
dealer counterparties. Credit limits are set to control potential exposure
arising from repurchase and resale agreements, stock borrowing or loan
facilities, derivative financial instruments and other products that may give
rise to secured and unsecured credit exposure.
Global Credit Department professionals assess the creditworthiness of the
Company's counterparties, assign an internal credit rating that reflects the
Global Credit Department's quantitative and qualitative assessment of each
counterparty's relative probability of default, and assign or recommend credit
limits and requirements. In addition, credit and quantitative analysts assess
the quality and acceptability of collateral, measure potential credit exposure
associated with certain transactions, monitor compliance with credit limits,
obtain appropriate legal documentation and provide comprehensive credit risk
reporting for senior management.
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivatives contracts in a
gain position at November 30, 2006 and 2005 approximated $4.99 billion and $4.41
billion, respectively. Exchange-traded financial instruments, which typically
are guaranteed by a highly rated clearing organization, have margin requirements
that substantially mitigate risk of credit loss.
72
RISK MANAGEMENT
continued
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of November 30, 2006:
Over-the-Counter Derivatives Credit Exposure(1)
Percentage
Exposure, of Exposure,
Net of Net of
Rating(2) Exposure Collateral(3) Collateral(4) Collateral
- -------------------------------------------------------------------------------------------------------
(in millions)
- -------------------------------------------------------------------------------------------------------
AAA $ 1,391 $ 104 $ 1,359 27%
AA 5,829 4,053 1,949 39%
A 2,794 1,764 1,085 22%
BBB 455 455 200 4%
BB and lower 1,379 2,574 316 6%
Non-rated 88 15 83 2%
- -------------------------------------------------------------------------------------------------------
(1) Excluded are covered transactions structured to ensure that the market
values of collateral will at all times equal or exceed the related exposures.
The net exposure for these transactions will, under all circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's Credit
Department, converted to rating agency equivalents.
(3) For lower-rated counterparties, the Company generally receives collateral in
excess of the current market value of derivatives contracts.
(4) In calculating exposure net of collateral, collateral amounts are limited to
the amount of current exposure for each counterparty. Excess collateral is not
applied to reduce exposure because such excess in one counterparty portfolio
cannot be applied to deficient collateral in a different counterparty portfolio.
The Company establishes potential exposure limits across a variety of financing
and trading products for all counterparties on a group and individual entity
basis. Potential exposure is the statistically estimated net credit exposure
associated with adverse market moves over the life of transactions at a 97.7%
confidence interval. The potential exposure is estimated daily, using
sophisticated, internally developed risk models that employ Monte Carlo
simulations. Potential exposure estimates consider the size and maturity of
contracts; the volatility of, and correlations among, the underlying assets,
indices and currencies; settlement mechanisms; rights to demand additional
collateral; and other legally enforceable credit mitigants such as third-party
guarantees or insurance.
The Company establishes country concentration limits and monitors actual and
potential exposures, including both position and counterparty exposures, in
emerging markets. Sovereign risk analysts evaluate international macroeconomic
conditions and recommend country concentration limits. The Company limits and
monitors its exposure to sovereign default, devaluation and inconvertibility of
local currencies.
The Margin Department is responsible for evaluating the risk of extending loans
to the Company's customers secured by certain marketable securities. The
department evaluates the acceptability of collateral and actively monitors to
ensure that collateral received meets regulatory and internal requirements.
Internal (or "house") margin requirements generally exceed minimum regulatory
requirements and may be adjusted for specific securities based on volatility or
liquidity. The Special Credit Services unit of the Global Credit Department
evaluates and sets terms for loans secured by restricted or control stock,
emerging markets securities and concentrated or less liquid securities.
The Risk Management Department is responsible for monitoring the market risk of
the Company's proprietary positions. As part of its duties, the group evaluates
the credit quality of securities positions held in inventory to quantify and
limit the risk to the Company of issuer default or changes in credit spreads. In
a similar manner, the department also evaluates the credit quality of reference
issuer obligations associated with derivatives contracts whose values are linked
to the credit quality or credit spread trading level of reference issuers. The
department monitors issuer credit exposures across the various cash and
derivatives trading desks that trade in securities or derivatives of the same or
73
RISK MANAGEMENT
continued
related issuers to monitor aggregate exposures. This process also aggregates
counterparty credit exposures with issuer exposures to produce a more
comprehensive perspective on the Company's exposure to credit risks.
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities, securities of
a single issuer, including governments, issuers located in a particular country
or geographic area, or issuers engaged in a particular industry. Positions taken
and commitments made by the Company, including underwriting, often involve
substantial amounts and significant exposure to individual issuers and
businesses, including non-investment-grade issuers. At November 30, 2006, the
Company's most significant concentrations are related to US government and
agency inventory positions, including those of the Federal National Mortgage
Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation
("Freddie Mac"). In addition, a substantial portion of the collateral held by
the Company for reverse repurchase agreements consists of securities issued by
the US government and agencies. The Company seeks to limit concentration risk
through the use of the systems and procedures described in the preceding
discussions of market and credit risk.
Global Clearing Services carries the accounts of professional clients, including
floor traders and specialists, arbitrageurs, broker-dealers, hedge funds and
fund of funds groups. These clients employ a wide variety of trading styles,
including option hedging, market-neutral statistical arbitrage, risk arbitrage,
hedged convertible strategies and multiple fixed income strategies. Trading
strategies are employed in both domestic and international markets. The
extension of credit, via secured margin debt for a given customer, is determined
by the Risk Department of Global Clearing Services using a systematic analysis
of the securities held and trading strategy that such customer employs. Global
Clearing Services has established a risk-based margin lending policy under which
the minimum capital requirement for a portfolio may be greater than the
applicable regulatory capital requirement for the sum of the underlying
constituents of that portfolio.
Client portfolios are analyzed and evaluated daily through extensive stress
testing simulations designed to estimate market-related risk under different
scenarios. Using its internally developed risk management system, known as RACS
(Risk Analytic Control System), the Risk Department is able to analyze every
professional client's portfolio prior to each market opening and track that
portfolio on an intra-day basis. Client positions are simulated across more than
200 different scenarios, resulting in a wide variety of potential profit and
loss possibilities. Some basic assumptions used in the analysis are minimum
portfolio moves of 20% as well as minimum moves in individual securities of 25%
or more. Other scenarios include price movement tests of 1 and 2 standard
deviations, fixed percentage moves, beta-weighted and market
capitalization-driven extreme price moves. Scenarios are constructed in such a
way as to assess position and portfolio sensitivities to changes in underlying
prices, volatilities, interest rates, credit spreads, cross-currency rates and
forward time horizons. Experienced managers review the results of the stress
testing to determine whether additional margin is necessary. In addition to
client-level security and portfolio analysis, the system produces over 40
various reports that provide multi-dimensional views, which include industry
exposures, country/region exposures and security concentration and liquidity
risk.
The Loan Portfolio Management Group is responsible for managing the credit risk
in the Company's loan portfolio. The group is responsible for evaluating
transactions originated by investment bankers and advising on pricing or other
considerations during the due diligence process. Specific portfolio limits have
been established for the various types of lending, and there are formally
approved guidelines for hedging the loan portfolio.
OPERATIONAL RISK
Operational risk is the potential for loss arising from inadequate or failed
internal processes, people or systems, or from external events. This includes,
but is not limited to, limitations in the Company's financial systems and
controls, deficiencies in legal documentation, non-compliance with the execution
of legal, regulatory and fiduciary responsibilities, deficiencies in technology
and the risk of loss attributable to operational problems. These risks are less
direct than credit and market risk, but managing them is critical, particularly
in a rapidly changing environment with
74
RISK MANAGEMENT
continued
increasing regulation and transaction volumes. In an effort to reduce or
mitigate these risks, the Company has established and maintains an internal
control environment that incorporates various control mechanisms at different
levels throughout the organization and within such departments as Controllers,
Operations, Legal, Risk Management, Global Credit, Compliance and Internal
Audit. These control mechanisms are designed to better ensure that operational
policies and procedures are being followed and that the Company's various
businesses are operating within established corporate policies and limits.
In addition to these existing control mechanisms, the Company has an Operational
Risk Management function, which focuses on facilitating internal communication,
disclosure, and supervisory review of operational risk management practices. The
Operational Risk Management function has responsibilities related to the
development, consistent application and oversight of operational risk policies,
processes and procedures firmwide. The function is independent of all business
units and formally reports to the chief risk officer.
Management of the Company has established and maintains effective internal
control over financial reporting. Internal control over financial reporting is a
process designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles. The
Company's internal control over financial reporting includes those policies and
procedures that: (i) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the
assets of the Company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles and that receipts and
expenditures of the Company are being made only in accordance with
authorizations of management and directors of the Company; and (iii) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of the Company's assets that could have a
material effect on the financial statements.
The Company has invested heavily in technology over the years to have the
ability to gather and process information efficiently and to handle the wide
variety of products and services the Company offers. In addition, the Company's
investment in technology allows the Company to communicate information
efficiently and securely to customers and to groups within the Company.
LEGAL RISK
Legal risk includes the risk of non-compliance with applicable legal and
regulatory requirements and the risk that a counterparty will not perform on its
obligations due to non-credit-related conditions, including counterparty legal
authority and capacity. The Company is generally subject to extensive regulation
in the various jurisdictions in which it conducts its business. The Company has
established procedures based on legal and regulatory requirements on a worldwide
basis that are designed to ensure compliance with applicable statutory and
regulatory requirements. The Company has established policies and procedures in
an effort to mitigate the risk that counterparty performance obligations will be
unenforceable.
OTHER RISKS
Other risks encountered by the Company include political, regulatory and tax
risks. These risks reflect the potential impact that changes in local and
international laws, regulatory requirements or tax statutes have on the
economics and viability of current or future transactions. In an effort to
mitigate these risks, the Company seeks to continuously review new and pending
regulations and legislation and participates in various industry interest
groups.
75
THE BEAR STEARNS COMPANIES INC.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of The Bear Stearns Companies Inc. and subsidiaries (the "Company")
is responsible for establishing and maintaining adequate internal control over
financial reporting. Internal control over financial reporting is a process
designed under the supervision of the Company's principal executive and
principal financial officers to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of the Company's
financial statements for external purposes in accordance with generally accepted
accounting principles.
The Company's internal control over financial reporting includes those policies
and procedures that: (1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the Company; (2) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles and that
receipts and expenditures of the Company are being made only in accordance with
authorizations of management and directors of the Company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of the Company's assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
The Company's management assessed the effectiveness of the Company's internal
control over financial reporting as of November 30, 2006. In making this
assessment, the Company's management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
Internal Control-Integrated Framework. Based on its assessment, management
believes that, as of November 30, 2006, the Company's internal control over
financial reporting is effective based on those criteria.
The Company's independent registered public accounting firm has audited
management's assessment of the effectiveness of the Company's internal control
over financial reporting as of November 30, 2006, as stated in their report,
appearing on page 74.
76
THE BEAR STEARNS COMPANIES INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of The Bear Stearns
Companies Inc.
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that The Bear
Stearns Companies Inc. and subsidiaries (the "Company") maintained effective
internal control over financial reporting as of November 30, 2006, based on
criteria established in Internal Control--Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed by,
or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel, to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, management's assessment that the Company maintained effective
internal control over financial reporting as of November 30, 2006, is fairly
stated, in all material respects, based on the criteria established in Internal
Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Also in our opinion, the Company
maintained, in all material respects, effective internal control over financial
reporting as of November 30, 2006, based on the criteria established in Internal
Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated statement of
financial condition as of November 30, 2006 and the related consolidated
statements of income, cash flows and changes in stockholders' equity for the
year ended November 30, 2006 of the Company and our report dated February 12,
2007 expressed an unqualified opinion on those financial statements.
/s/ Deloitte & Touche LLP
New York, New York
February 12, 2007
77
THE BEAR STEARNS COMPANIES INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of The Bear Stearns
Companies Inc.
We have audited the accompanying consolidated statements of financial condition
of The Bear Stearns Companies Inc. and subsidiaries (the "Company") as of
November 30, 2006 and 2005, and the related consolidated statements of income,
cash flows and changes in stockholders' equity for each of the three years in
the period ended November 30, 2006. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of The Bear Stearns Companies Inc. and
subsidiaries as of November 30, 2006 and 2005, and the results of their
operations and their cash flows for each of the three years in the period ended
November 30, 2006, in conformity with accounting principles generally accepted
in the United States of America.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of the Company's
internal control over financial reporting as of November 30, 2006, based on the
criteria established in Internal Control--Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission and our report
dated February 12, 2007 expressed an unqualified opinion on management's
assessment of the effectiveness of the Company's internal control over financial
reporting and an unqualified opinion on the effectiveness of the Company's
internal control over financial reporting.
/s/ Deloitte & Touche LLP
New York, New York
February 12, 2007
78
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF INCOME
Fiscal Years Ended November 30, 2006 2005 2004
- ------------------------------------------------------------------------------------------------------------------------
(in thousands, except share and per share data)
- ------------------------------------------------------------------------------------------------------------------------
REVENUES
Commissions $ 1,162,686 $ 1,200,454 $ 1,178,074
Principal transactions 4,995,012 3,836,017 3,595,595
Investment banking 1,333,751 1,037,213 1,031,051
Interest and dividends 8,536,029 5,107,019 2,317,315
Asset management and other income 523,941 371,744 299,867
- ------------------------------------------------------------------------------------------------------------------------
Total revenues 16,551,419 11,552,447 8,421,902
Interest expense 7,324,254 4,141,653 1,609,019
- ------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense 9,227,165 7,410,794 6,812,883
- ------------------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 4,343,499 3,553,216 3,253,862
Floor brokerage, exchange and clearance fees 226,882 221,553 230,652
Communications and technology 478,780 401,673 369,176
Occupancy 197,756 167,825 141,916
Advertising and market development 147,262 126,678 113,800
Professional fees 279,942 229,198 197,086
Other expenses 406,414 503,592 484,237
- -----------------------------------------------------------------------------------------------------------------------
Total non-interest expenses 6,080,535 5,203,735 4,790,729
- -----------------------------------------------------------------------------------------------------------------------
Income before provision for income taxes 3,146,630 2,207,059 2,022,154
Provision for income taxes 1,092,759 744,882 677,421
- -----------------------------------------------------------------------------------------------------------------------
Net income $ 2,053,871 $ 1,462,177 $ 1,344,733
Preferred stock dividends (21,363) (24,321) (28,072)
- -----------------------------------------------------------------------------------------------------------------------
Net income applicable to common shares $ 2,032,508 $ 1,437,856 $ 1,316,661
=======================================================================================================================
Basic earnings per share $ 15.79 $ 11.42 $ 10.88
Diluted earnings per share $ 14.27 $ 10.31 $ 9.76
=======================================================================================================================
Weighted average common shares outstanding:
Basic 131,711,382 130,326,947 127,468,061
Diluted 148,575,469 147,467,992 145,284,589
=======================================================================================================================
See Notes to Consolidated Financial Statements.
79
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
As of November 30, 2006 2005
- -----------------------------------------------------------------------------------------------------------------------------
(in thousands, except share data)
- -----------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 4,595,184 $ 5,859,133
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 8,803,684 5,269,676
Securities purchased under agreements to resell 38,838,279 42,647,603
Securities received as collateral 19,648,241 12,426,383
Securities borrowed 80,523,355 62,915,010
Receivables:
Customers 29,481,799 31,272,881
Brokers, dealers and others 6,119,348 3,544,806
Interest and dividends 744,542 433,305
Financial instruments owned, at fair value 109,200,487 90,003,591
Financial instruments owned and pledged as collateral, at fair value 15,967,964 12,880,333
------------------------------------
Total financial instruments owned, at fair value 125,168,451 102,883,924
Assets of variable interest entities and mortgage loan special purpose entities 30,303,275 15,151,699
Property, equipment and leasehold improvements, net of accumulated depreciation and
amortization of $1,152,279 and $1,011,036 in 2006 and 2005, respectively 479,637 451,247
Other assets 5,726,800 4,436,970
- ----------------------------------------------------------------------------------------------------------------------------
Total Assets $ 350,432,595 $ 287,292,637
============================================================================================================================
LIABILITIES & STOCKHOLDERS' EQUITY
Short-term borrowings $ 29,062,714 $ 20,015,727
Securities sold under agreements to repurchase 69,749,675 66,131,617
Obligation to return securities received as collateral 19,648,241 12,426,383
Securities loaned 11,451,324 10,104,325
Payables:
Customers 72,988,661 69,870,570
Brokers, dealers and others 3,396,835 2,657,178
Interest and dividends 1,123,348 796,956
Financial instruments sold, but not yet purchased, at fair value 42,256,544 33,022,234
Liabilities of variable interest entities and mortgage loan special purpose entities 29,079,552 14,321,285
Accrued employee compensation and benefits 2,895,047 1,853,416
Other liabilities and accrued expenses 2,081,354 1,811,898
Long-term borrowings 54,569,916 43,489,616
- ----------------------------------------------------------------------------------------------------------------------------
Total Liabilities 338,303,211 276,501,205
- ----------------------------------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 17)
STOCKHOLDERS' EQUITY
Preferred stock 359,156 372,326
Common stock, $1.00 par value; 500,000,000 shares authorized as of
November 30, 2006 and 2005; 184,805,847 shares issued
as of November 30, 2006 and 2005 184,806 184,806
Paid-in capital 4,578,972 4,109,166
Retained earnings 9,384,595 7,492,951
Employee stock compensation plans 2,221,997 2,600,186
Unearned compensation (155,596) (143,302)
Treasury stock, at cost:
Common stock: 67,396,876 and 70,937,640 shares as of November 30, 2006 and
2005, respectively (4,444,546) (3,824,701)
- ----------------------------------------------------------------------------------------------------------------------------
Total Stockholders' Equity 12,129,384 10,791,432
- ----------------------------------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 350,432,595 $ 287,292,637
============================================================================================================================
See Notes to Consolidated Financial Statements.
Note: Certain prior year items have been reclassified to conform to the current
year's presentation.
80
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Fiscal Years Ended November 30, 2006 2005 2004
- ------------------------------------------------------------------------------------------------------------------------------------
(in thousands)
- ------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 2,053,871 $ 1,462,177 $ 1,344,733
Adjustments to reconcile net income to cash used in operating activities:
Non-cash items included in net income:
Depreciation and amortization 350,367 276,658 221,173
Deferred income taxes (85,325) 112,937 (82,575)
Employee stock compensation plans 1,009,519 801,216 763,162
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or segregated in
compliance with federal regulations (3,534,008) (846,978) 4,234,367
Securities borrowed, net of securities loaned (16,261,346) 6,263,989 7,595,123
Net receivables from brokers, dealers and others (1,834,885) (552,783) 2,996,454
Financial instruments owned (21,415,324) (26,938,437) (18,710,277)
Other assets (1,538,505) (831,155) (672,940)
Securities sold under agreements to repurchase, net of securities
purchased under agreements to resell 7,427,382 10,274,913 (432,360)
Net payables to customers 4,909,173 (8,671,958) (3,329,522)
Financial instruments sold, but not yet purchased 8,895,281 3,546,354 1,237,709
Accrued employee compensation and benefits 207,082 170,966 302,727
Other liabilities and accrued expenses 595,848 494,099 2,191,135
- ------------------------------------------------------------------------------------------------------------------------------------
Cash used in operating activities (19,220,870) (14,438,002) (2,341,091)
- ------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (180,669) (202,911) (128,433)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash used in investing activities (180,669) (202,911) (128,433)
- ------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from (payments for) short-term borrowings 9,046,987 7,804,896 (1,176,830)
Proceeds from issuances of long-term borrowings 19,891,429 15,996,998 11,248,786
Payments for retirement/repurchase of long-term borrowings (10,249,865) (7,273,206) (6,653,510)
Proceeds from issuances of derivatives with a financing element, net 339,029 254,771 273,849
Redemption of preferred stock issued by a subsidiary -- -- (300,000)
Issuance of common stock 289,402 201,851 235,812
Cash retained resulting from tax deductibility under share-based
payment arrangements 363,044 426,055 163,887
Redemption of preferred stock (13,115) (75,822) (89,037)
Treasury stock purchases--common stock (1,374,064) (869,629) (780,827)
Cash dividends paid (155,257) (139,253) (116,791)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash provided by financing activities 18,137,590 16,326,661 2,805,339
- ------------------------------------------------------------------------------------------------------------------------------------
Net (decrease) increase in cash and cash equivalents (1,263,949) 1,685,748 335,815
Cash and cash equivalents, beginning of year 5,859,133 4,173,385 3,837,570
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 4,595,184 $ 5,859,133 $ 4,173,385
====================================================================================================================================
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest were $7.93 billion, $4.30 billion and $1.66 billion
during the fiscal years ended November 30, 2006, 2005 and 2004, respectively.
Cash payments for income taxes, net of refunds, were $708.9 million, $146.3
million and $524.5 million for the fiscal years ended November 30, 2006, 2005
and 2004, respectively. Cash payments for income taxes, net of refunds, would
have been $1.07 billion, $572.4 million and $688.4 million for the fiscal years
ended November 30, 2006, 2005 and 2004, respectively, if increases in the value
of equity instruments issued under share-based payment arrangements had not been
deductible in determining taxable income.
See Notes to Consolidated Financial Statements.
Note: Certain prior year items have been reclassified to conform to the current
year's presentation.
81
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Common Employee Treasury
Stock Stock Stock -
Preferred $1 Par Paid-in Retained Compensation Unearned Common
Stock Value Capital Earnings Plans Compensation Stock Total
- ------------------------------------------------------------------------------------------------------------------------------------
(in thousands, except
share and per share data)
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2003 $538,415 $184,806 $3,245,380 $4,954,508 $2,299,170 $(188,952) $(3,563,239) $ 7,470,088
Net income 1,344,733
Dividends declared--
Common ($0.85 per share) (94,888) 7,199
Preferred (28,712)
Treasury stock--
Common stock purchased (780,827)
(9,236,141 shares)
Common stock issued out of
treasury (10,454,157 shares) 41,631 (272,293) 468,517
Redemption of preferred stock (90,267) 1,230
Income tax benefit related to
distributions from employee
stock compensation plans 163,887
Unearned employee stock
compensation, net 30,290
Employee stock compensation
awards, net 98,940 632,803
Amortization of preferred
stock issue costs (1,459)
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2004 $448,148 $184,806 $3,548,379 $6,176,871 $2,666,879 $(158,662) $(3,875,549) $ 8,990,872
Net income 1,462,177
Dividends declared--
Common ($1.00 per share) (121,245) 7,181
Preferred (24,852)
Treasury stock--
Common stock purchased
(8,483,483 shares) (869,629)
Common stock issued out of
treasury
(18,565,624 shares) 12,776 (729,226) 920,477
Redemption of preferred stock (75,822)
Income tax benefit related to
distributions from employee
stock compensation plans 426,055
Unearned employee stock
compensation, net 15,360
Employee stock compensation
awards, net 123,198 655,352
Amortization of preferred stock
issue costs (1,242)
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2005 $372,326 $184,806 $4,109,166 $7,492,951 $2,600,186 $(143,302) $(3,824,701) $10,791,432
====================================================================================================================================
82
THE BEAR STEARNS COMPANIES INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(CONTINUED)
Common Employee Treasury
Stock Stock Stock -
Preferred $1 Par Paid-in Retained Compensation Unearned Common
Stock Value Capital Earnings Plans Compensation Stock Total
- ------------------------------------------------------------------------------------------------------------------------------------
(in thousands, except
share and per share data)
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2005 $372,326 $184,806 $4,109,166 $7,492,951 $2,600,186 $(143,302) $(3,824,701) $10,791,432
Net income 2,053,871
Dividends declared--
Common ($1.12 per share) (140,821) 7,417
Preferred (21,461)
Treasury stock--
Common stock purchased
(10,582,214 shares) (1,374,064)
Common stock issued out
of treasury
(14,122,978 shares) 91,053 (551,441) 754,219
Redemption of preferred
stock (13,170) 55
Income tax benefit related to
distributions
from employee stock
compensation plans 363,044
Unearned employee stock
compensation, net (12,294)
Employee stock compensation
awards, net 16,609 165,835
Amortization of preferred
stock issue costs (900)
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE, NOVEMBER 30, 2006 $359,156 $184,806 $4,578,972 $9,384,595 $2,221,997 $(155,596) $(4,444,546) $12,129,384
====================================================================================================================================
See Notes to Consolidated Financial Statements.
83
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets is
comprised of the institutional equities, fixed income and investment
banking areas. Global Clearing Services provides clearance-related
services for prime brokerage clients and clearance on a fully disclosed
basis for introducing broker-dealers. Wealth Management is comprised of
the private client services ("PCS") and asset management areas. See Note
19, "Segment and Geographic Area Data," in the Notes to Consolidated
Financial Statements for a complete description of the Company's principal
segments. The Company also conducts significant activities through other
wholly owned subsidiaries, including: Bear Stearns Global Lending Limited;
Custodial Trust Company; Bear Stearns Financial Products Inc. ("BSFP");
Bear Stearns Capital Markets Inc.; Bear Stearns Credit Products Inc.; Bear
Stearns Forex Inc.; EMC Mortgage Corporation; Bear Stearns Commercial
Mortgage, Inc.; and through its majority-owned subsidiary Bear Hunter
Holdings LLC. The Company participates, through Bear Hunter Holdings LLC,
in specialist activities on the New York Stock Exchange ("NYSE"), American
Stock Exchange ("AMEX") and International Securities Exchange ("ISE").
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company,
its wholly owned subsidiaries and other entities in which the Company has
a controlling interest. All material intercompany transactions and
balances have been eliminated in consolidation. Certain prior year amounts
have been reclassified to conform to the current year's presentation. In
accordance with Financial Accounting Standards Board ("FASB")
Interpretation ("FIN") No. 46 (R), "Consolidation of Variable Interest
Entities (revised December 2003)--an interpretation of ARB No. 51" ("FIN
No. 46 (R)"), the Company also consolidates any variable interest entities
("VIEs") for which it is the primary beneficiary. The assets and related
liabilities of such variable interest entities have been shown in the
Consolidated Statements of Financial Condition in the captions "Assets of
variable interest entities and mortgage loan special purpose entities" and
"Liabilities of variable interest entities and mortgage loan special
purpose entities." See Note 6, "Variable Interest Entities and Mortgage
Loan Special Purpose Entities," in the Notes to Consolidated Financial
Statements.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
The consolidated financial statements are prepared in conformity with
accounting principles generally accepted in the United States of America.
These principles require management to make certain estimates and
assumptions, including those regarding inventory valuations, stock-based
compensation, certain accrued liabilities and the potential outcome of
litigation and tax matters, which may affect the amounts reported in the
consolidated financial statements and accompanying notes. Actual results
could differ materially from these estimates.
As of November 30, 2006, the Company elected, under FASB Interpretation
No. 39, "Offsetting Amounts Related to Certain Contracts," to net the
payable or receivable relating to the fair value of cash collateral
received or paid associated with its derivatives inventory, on a
counterparty basis, provided that the legal right of offset exists under a
master netting agreement. The Company believes this presentation is
preferable as compared to a gross presentation as it is a better
representation of the Company's credit exposure related to these
derivative contracts. The Consolidated Statement of Financial Condition as
of November 30, 2005 and the Consolidated Statements of Cash Flows for the
years ended November 30, 2005 and 2004 have been retrospectively adjusted
to conform to the current year's
84
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
presentation. The amounts netted reduced Financial Instruments Owned and
Payable to Customers, by $6.3 billion as of November 30, 2006 and $3.4
billion as of November 30, 2005, and reduced Financial Instruments Sold,
But Not Yet Purchased and Receivable From Customers, by $3.2 billion as of
November 30, 2006 and $2.0 billion as of November 30, 2005.
For the year ended November 30, 2006, the Company changed its presentation
of segments to allocate certain revenues (predominantly interest) as well
as certain corporate administrative expenses from "Other" to its three
business segments. Certain legal and CAP Plan costs continue to be
included in "Other." Management believes that these changes provide an
improved representation of each segment's contribution to net revenues and
pre-tax income for which to evaluate performance. These reclassifications
were also made to prior year amounts to conform to the current year's
presentation and are reflected in Note 19, "Segment and Geographic Area
Data" in Notes to Consolidated Financial Statements.
FINANCIAL INSTRUMENTS
Proprietary securities, futures and other derivatives transactions are
recorded on a trade-date basis. Financial instruments owned and financial
instruments sold, but not yet purchased, including contractual commitments
arising pursuant to futures, forward and option contracts, interest rate
swaps and other derivative contracts, are recorded at fair value with the
resulting net unrealized gains and losses reflected in "Principal
Transactions" revenues in the Consolidated Statements of Income.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined
based on other relevant factors, including dealer price quotations, price
activity for equivalent instruments and valuation pricing models.
Valuation pricing models consider time value, yield curve and volatility
factors, prepayment speeds, default rates, loss severity, current market
and contractual prices for the underlying financial instruments, as well
as other measurements.
The Company followed Emerging Issues Task Force ("EITF") Statement No.
02-3, "Issues Involved in Accounting for Derivative Contracts Held for
Trading Purposes and Contracts Involved in Energy Trading and Risk
Management Activities," through November 30, 2006. This guidance generally
eliminates the practice of recognizing profit at the inception of a
derivative contract unless the fair value of the derivative is obtained
from a quoted market price in an active market or is otherwise evidenced
by comparison to other observable current market transactions or based on
a valuation technique that incorporates observable market data. The
Company intends to adopt Statement of Financial Accounting Standards
("SFAS") No. 157, "Fair Value Measurements," in the first quarter of 2007.
SFAS No. 157 nullifies the consensus reached in EITF No. 02-3, which
prohibited recognition of day one gains or losses on certain derivative
contracts. See "Accounting and Reporting Developments" in Note 1 of Notes
to Consolidated Financial Statements for a complete discussion of SFAS No.
157.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the consolidated financial
statements at their initial cost until significant transactions or
developments indicate that a change in the carrying value of the
securities is appropriate. Generally, the carrying values of these
securities will be increased only in those instances where market values
are readily ascertainable by reference to substantial transactions
occurring in the marketplace or quoted market prices. Reductions to the
carrying value of these securities are made when the Company's estimate of
net realizable value has declined below the carrying value.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company follows SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Derivative Instruments and Certain Hedging Activities," and SFAS
No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities," which establishes accounting and reporting standards for
stand-alone derivative instruments,
85
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
derivatives embedded within other contracts or securities, and hedging
activities. Accordingly, all derivatives, whether stand-alone or embedded
within other contracts or securities (except in narrowly defined
circumstances), are carried in the Company's Consolidated Statements of
Financial Condition at fair value, with changes in fair value recorded in
current earnings in "Principal Transactions" revenues. Designated hedged
items in fair value hedging relationships are marked for the risk being
hedged, with such changes recorded in current earnings.
CUSTOMER TRANSACTIONS
Customer securities transactions are recorded on the Consolidated
Statements of Financial Condition on a settlement date basis, which is
generally three business days after trade date, while the related
commission revenues and expenses are recorded on a trade-date basis.
Receivables from and payables to customers include amounts related to both
cash and margin transactions. Securities owned by customers, including
those that collateralize margin or other similar transactions, are
generally not reflected in the Consolidated Statements of Financial
Condition.
MORTGAGE SERVICING ASSETS, FEES AND ADVANCES
Mortgage servicing rights ("MSRs"), which are included in "Other Assets"
on the Consolidated Statements of Financial Condition, are reported at the
lower of amortized cost or market. MSRs are amortized in proportion to and
over the period of estimated net servicing income. MSRs are periodically
evaluated for impairment based on the fair value of those rights
determined by using market-based models that discount anticipated future
net cash flows considering loan prepayment predictions, interest rates,
default rates, servicing costs and other economic factors. For purposes of
impairment evaluation and measurement, the Company stratifies MSRs by
securitizations, which are collateralized by loans with similar
predominant risk characteristics. The excess of amortized cost over market
value, if any, is reflected as a valuation allowance as of balance sheet
dates.
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected net of MSRs amortization
and impairment in "Investment Banking" revenues in the Consolidated
Statements of Income. Contractual servicing fees are recognized when
earned based on the terms of the servicing agreement. All other fees are
recognized when received. In the normal course of its business, the
Company makes principal, interest and other servicing advances to external
investors on mortgage loans serviced for these investors. Such advances
are generally recoverable from the mortgagors, related securitization
trusts or from the proceeds received from the sales of the underlying
properties. A charge to expense is recognized to the extent that servicing
advances are estimated to be uncollectible under the provisions of the
servicing contracts.
TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF
LIABILITIES
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a Qualifying Special Purpose Entity ("QSPE") or has the right to pledge
or exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. The Company derecognizes
financial assets transferred in securitizations provided that such
transfer meets all of these criteria.
Mortgage related transactions, net of certain direct costs, are recorded
in "Principal Transactions" revenues in the Consolidated Statements of
Income.
86
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
COLLATERALIZED SECURITIES TRANSACTIONS
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal Transactions" revenues in the
Consolidated Statements of Income. Reverse repurchase agreements and
repurchase agreements are presented in the Consolidated Statements of
Financial Condition on a net-by-counterparty basis, where permitted by
generally accepted accounting principles. It is the Company's general
policy to take possession of securities with a market value in excess of
the principal amount loaned plus the accrued interest thereon, in order to
collateralize reverse repurchase agreements. Similarly, the Company is
generally required to provide securities to counterparties to
collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for
additional collateral to be obtained, or excess collateral returned. It is
the Company's policy to value collateral and to obtain additional
collateral, or to retrieve excess collateral from counterparties, when
deemed appropriate.
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
INVESTMENT BANKING AND ADVISORY SERVICES
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized. Investment banking and advisory services revenues are
presented net of transaction-related expenses.
COMMISSIONS
Commission revenues primarily include fees from executing and clearing
client transactions on stock, options and futures markets worldwide. These
fees are recognized on a trade-date basis. The Company records its share
of the commission under certain commission sharing arrangements where the
Company is acting as agent for another broker, in accordance with EITF
Statement No. 99-19, "Reporting Revenue Gross as a Principal versus Net as
an Agent."
ASSET MANAGEMENT AND OTHER INCOME
The Company receives advisory fees for investment management. In addition,
the Company receives performance incentive fees for managing certain
funds. Advisory fees are recognized over the period of advisory service.
Unearned advisory fees are treated as deferred revenues and are included
in "Other Liabilities" in the accompanying Consolidated Statements of
Financial Condition. Performance incentive fees are recognized throughout
the year as they become realizable based on achievement of specified
performance targets.
FIXED ASSETS
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
87
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
GOODWILL AND IDENTIFIABLE INTANGIBLE ASSETS
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets."
EARNINGS PER SHARE
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income
applicable to common shares, adjusted for costs related to vested shares
under the Capital Accumulation Plan for Senior Managing Directors, as
amended ("CAP Plan"), as well as the effect of the redemption of preferred
stock, by the weighted average number of common shares outstanding. Common
shares outstanding includes vested units issued under certain stock
compensation plans, which will be distributed as shares of common stock.
Diluted EPS includes the determinants of basic EPS and, in addition, gives
effect to dilutive potential common shares related to stock compensation
plans.
STOCK-BASED COMPENSATION
Effective December 1, 2005, the Company adopted the provision of SFAS No.
123 (R), "Shared-Based Payment." SFAS No. 123 (R) is a revision of SFAS
No. 123, "Accounting for Stock-Based Compensation," and supersedes
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS No. 123 (R) eliminates the ability to account for share-based
compensation transactions using APB No. 25 and requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the financial statements using a fair value-based method.
The Company adopted SFAS No. 123 (R) using the modified prospective
method. Because the fair value recognition provisions of SFAS No. 123 and
SFAS No. 123 (R) were materially consistent under the Company's equity
plans, the adoption of SFAS No. 123 (R) did not have a material impact on
the Company's financial position or results of operations.
Prior to the Company's adoption of SFAS No. 123 (R), tax benefits in
excess of recognized compensation costs were reported as operating cash
flows. SFAS No. 123 (R) requires excess tax benefits to be reported as a
financing cash inflow.
The Company previously elected to adopt fair value accounting for
stock-based compensation consistent with SFAS No. 123, using the
prospective method with guidance provided by SFAS No. 148, "Accounting for
Stock-Based Compensation--Transition and Disclosure," effective December
1, 2002. As a result, commencing with options granted after November 30,
2002, the Company expenses the fair value of stock options issued to
employees over the related vesting period. Prior to December 1, 2002, the
Company had elected to account for its stock-based compensation plans
using the intrinsic value method prescribed by APB No. 25, as permitted by
SFAS No. 123. Under the provisions of APB No. 25, compensation cost for
stock options was measured as the excess, if any, of the quoted market
price of the Company's common stock at the date of grant over the amount
an employee must pay to acquire the stock. Accordingly, no compensation
expense was recognized for stock option awards granted prior to December
1, 2002 because the exercise price was at the fair market value of the
Company's common stock on the grant date.
The cost related to stock-based compensation included in net income for
the fiscal year ended November 30, 2006 has been fully determined under
the fair value-based method, and for the fiscal years ended November 30,
2005 and 2004 is less than that which would have been recognized if the
fair value-based method had been applied to stock option awards since the
original effective date of SFAS No. 123.
88
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The following table illustrates the effect on net income and earnings per
share if the fair value-based method had been applied to all outstanding
awards in each fiscal year.
Fiscal Years Ended November 30, 2005 2004
--------------------------------------------------------------------------
(in millions, except per share amounts)
--------------------------------------------------------------------------
Net income, as reported $1,462.2 $1,344.7
Add: Stock-based employee compensation plans
expense included in reported net income,
net of related tax effect 375.4 335.4
Deduct: Total stock-based employee compensation
plans expense determined under the fair value
based method, net of related tax effect (387.3) (367.6)
--------------------------------------------------------------------------
Pro forma net income $1,450.3 $1,312.5
==========================================================================
Earnings per share:
Basic--as reported $ 11.42 $ 10.88
Basic--pro forma $ 11.33 $ 10.63
Diluted--as reported $ 10.31 $ 9.76
Diluted--pro forma $ 10.23 $ 9.54
=========================================================================
CASH EQUIVALENTS
The Company has defined cash equivalents as liquid investments not held
for sale in the ordinary course of business with original maturities of
three months or less that are not part of the Company's trading inventory.
INCOME TAXES
The Company and certain of its subsidiaries file a US consolidated federal
income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the probability for additional assessments. Once
established, reserves are adjusted as information becomes available or
when an event requiring a change to the reserve occurs.
TRANSLATION OF FOREIGN CURRENCIES
Assets and liabilities denominated in foreign currencies are translated at
fiscal year-end rates of exchange, while income statement items are
translated at daily average rates of exchange during the fiscal year.
Comprehensive income was materially the same as net income for the Company
for the years ended November 30, 2006, 2005, and 2004. Gains or losses
resulting from foreign currency transactions are included in current
earnings.
ACCOUNTING AND REPORTING DEVELOPMENTS
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5,
"Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights." The EITF consensus requires a general
partner in a limited partnership to consolidate the limited partnership
unless the presumption of control is overcome. The general partner may
overcome this presumption of control and not consolidate the entity if the
limited partners have: (a) the substantive ability to dissolve or
liquidate the limited
89
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
partnership or otherwise remove the general partner without having to show
cause; or (b) substantive participating rights in managing the
partnership. This guidance became effective upon ratification by the FASB
on June 29, 2005 for all newly formed limited partnerships and for
existing limited partnerships for which the partnership agreements have
been modified. For all other limited partnerships, the guidance is
effective no later than the beginning of the first reporting period in
fiscal years beginning after December 15, 2005. As of December 1, 2006,
the Company has fully adopted EITF No. 04-5 for both newly formed
partnerships as well as partnerships entered into prior to June 29, 2005.
The adoption of EITF No. 04-5 did not have a material impact on the
consolidated financial statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments an amendment of FASB Statements No. 133 and
140." SFAS No. 155 permits companies to elect, on a
transaction-by-transaction basis, to apply a fair value measurement to
hybrid financial instruments that contain an embedded derivative that
would otherwise require bifurcation under SFAS No. 133. As permitted, the
Company adopted SFAS No. 155 on December 1, 2006 and elected to apply a
fair value measurement to all existing hybrid financial instruments that
meet the SFAS No. 155 definition. The Company has also elected the fair
value measurement for all appropriate hybrid financial instruments issued
on or after December 1, 2006. The adoption of SFAS No. 155 did not have a
material impact on the consolidated financial statements of the Company.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets--an amendment of FASB Statement No. 140." SFAS No. 156,
consistent with SFAS No. 140, requires that all separately recognized
servicing assets and liabilities be initially measured at fair value. For
subsequent measurements, SFAS No. 156 permits companies to choose between
using an amortization method or a fair value measurement method for
reporting purposes. SFAS No. 156 is effective as of the beginning of a
company's first fiscal year that begins after September 15, 2006. On
December 1, 2006, the Company adopted SFAS No. 156 and elected to measure
servicing assets at fair value. The adoption of this standard did not have
a material impact on the consolidated financial statements of the Company.
In April 2006, the FASB issued FASB Staff Position ("FSP") FIN No. 46
(R)-6, "Determining the Variability to Be Considered in Applying
Interpretation No. 46 (R)." This FSP addresses how a reporting enterprise
should determine the variability to be considered in applying FIN No. 46
(R). The variability that is considered in applying FIN No. 46 (R) affects
the determination of: (a) whether the entity is a variable interest
entity, (b) which interests are variable interests in the entity, and (c)
which party, if any, is the primary beneficiary of the VIE. FSP FIN No. 46
(R)-6 states that the design of the entity shall be considered in the
determination of variable interests. The Company adopted FSP FIN No. 46
(R)-6 on September 1, 2006. The adoption of this standard did not have a
material impact on the consolidated financial statements of the Company.
In July 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company expects to adopt the provisions of
FIN No. 48 beginning in the first quarter of 2008. The Company is
currently evaluating the impact, if any, the adoption of FIN No. 48 may
have on the consolidated financial statements of the Company.
In September 2006, the FASB issued SFAS No. 157, "Fair Value
Measurements." SFAS No. 157 defines fair value, establishes a framework
for measuring fair value and requires enhanced disclosures about fair
value measurements. SFAS No. 157 requires companies to disclose the fair
value of its financial instruments according to a fair value hierarchy.
The fair value hierarchy ranks the quality and reliability of the
information used to determine fair values.
90
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
Financial assets carried at fair value will be classified and disclosed in
one of the three categories in accordance with the hierarchy. The three
levels of the fair value hierarchy are:
o Level 1: Quoted market prices for identical assets or
liabilities in active markets.
o Level 2: Observable market-based inputs or unobservable inputs
that are corroborated by market data.
o Level 3: Unobservable inputs that are not corroborated by
market data.
Additionally, companies are required to provide enhanced disclosure
information regarding the activities of those financial instruments
classified within the level 3 category, including a rollforward analysis
of fair value balance sheet amounts for each major category of assets and
liabilities and disclosure of the unrealized gains and losses for level 3
positions held at the reporting date. SFAS No. 157 is effective for
financial statements issued for fiscal years beginning after November 15,
2007. Early adoption is permitted if the entity has not yet issued
financial statements for that fiscal year (including any interim periods).
The Company is planning to early adopt SFAS No. 157 in the first quarter
of fiscal 2007 as permitted, and does not expect that the adoption of SFAS
No. 157 will have a material impact on the consolidated financial
statements of the Company.
2. FAIR VALUE OF FINANCIAL INSTRUMENTS
Substantially all of the Company's assets and liabilities are carried at
contracted amounts that approximate fair value. Assets that are recorded
at contracted amounts approximating fair value consist largely of
short-term secured receivables, including reverse repurchase agreements,
securities borrowed, customer receivables and certain other receivables.
Similarly, the Company's short-term liabilities, such as bank loans,
commercial paper, medium-term notes, repurchase agreements, securities
loaned, customer payables and certain other payables, are recorded at
contracted amounts approximating fair value. These instruments generally
have variable interest rates and/or short-term maturities, in many cases
overnight, and accordingly, their fair values are not materially affected
by changes in interest rates.
The estimated fair value of the Company's long-term borrowings, based on
market rates of interest and current foreign exchange rates available to
the Company at November 30, 2006 for debt obligations of similar maturity,
approximates carrying value as a result of applying SFAS No. 133. The
Company uses derivatives to modify the interest rate characteristics of
its long- and short-term debt. The Company generally enters into interest
rate swaps and other transactions designed to either convert its
fixed-rate debt into floating-rate debt or otherwise hedge its exposure to
changes in interest rates.
3. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, as of November 30, 2006 and 2005, were as follows:
2006 2005
--------------------------------------------------------------------------
(in thousands)
FINANCIAL INSTRUMENTS OWNED:
US government and agency $ 7,151,703 $ 9,914,866
Other sovereign governments 356,201 1,159,265
Corporate equity and convertible debt 28,892,588 18,601,132
Corporate debt and other 33,924,116 21,571,914
Mortgages, mortgage- and asset-backed 43,226,699 40,297,016
Derivative financial instruments 11,617,144 11,339,731
--------------------------------------------------------------------------
$ 125,168,451 $ 102,883,924
==========================================================================
91
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED:
US government and agency $ 12,322,838 $ 10,115,133
Other sovereign governments 676,402 1,617,998
Corporate equity and convertible debt 12,623,291 6,900,004
Corporate debt and other 4,714,019 3,274,034
Mortgages, mortgage- and asset-backed 54,802 139,988
Derivative financial instruments 11,865,192 10,975,077
--------------------------------------------------------------------------
$ 42,256,544 $ 33,022,234
==========================================================================
As of November 30, 2006 and 2005, all financial instruments owned that
were pledged to counterparties where the counterparty has the right, by
contract or custom, to rehypothecate those securities are classified as
"Financial Instruments Owned and Pledged as Collateral, at Fair Value" in
the Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased, represent obligations
of the Company to purchase the specified financial instrument at the then-
current market price. Accordingly, these transactions result in
off-balance-sheet risk as the Company's ultimate obligation to repurchase
such securities may exceed the amount recognized in the Consolidated
Statements of Financial Condition.
CONCENTRATION RISK
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At November 30, 2006, the Company's most
significant concentrations are related to US government and agency
inventory positions, including those of the Federal National Mortgage
Association and the Federal Home Loan Mortgage Corporation. In addition, a
substantial portion of the collateral held by the Company for reverse
repurchase agreements consists of securities issued by the US government
and agencies.
4. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate and equity price risk. Derivative financial instruments represent
contractual commitments between counterparties that derive their value
from changes in an underlying interest rate, currency exchange rate, index
(e.g., Standard & Poor's 500 Index), reference rate (e.g., London
Interbank Offered Rate, or LIBOR), or asset value referenced in the
related contract. Some derivatives, such as futures contracts, certain
options and index-referenced warrants, are traded on an exchange. Other
derivatives, such as interest rate and currency swaps, caps, floors,
collars, swaptions, equity swaps and options, credit derivatives,
structured notes and forward contracts, are negotiated in the
over-the-counter markets. Derivatives generate both on- and
off-balance-sheet risks, depending on the nature of the contract.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to purchase or sell a financial instrument at a specific price
on or before an established date or dates. Financial instruments sold, but
not yet purchased may result in market and/or credit risk in excess of
amounts recorded in the Consolidated Statements of Financial Condition.
92
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
MARKET RISK
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Consolidated Statements of Financial Condition. The
Company's exposure to market risk is influenced by a number of factors,
including the relationships among and between financial instruments with
off-balance-sheet risk, the Company's proprietary securities, futures and
derivatives inventories as well as the volatility and liquidity in the
markets in which the financial instruments are traded. The Company
mitigates its exposure to market risk by entering into hedging
transactions, which may include over-the-counter derivative contracts or
the purchase or sale of interest-bearing securities, equity securities,
financial futures and forward contracts. In this regard, the utilization
of derivative instruments is designed to reduce or mitigate market risks
associated with holding dealer inventories or in connection with
arbitrage-related trading activities.
DERIVATIVES CREDIT RISK
Credit risk arises from the potential inability of counterparties to
perform in accordance with the terms of the contract. At any point in
time, the Company's exposure to credit risk associated with counterparty
non-performance is generally limited to the net replacement cost of
over-the-counter contracts, net of the value of collateral held. Such
financial instruments are reported at fair value on a net-by-counterparty
basis pursuant to enforceable netting agreements. As of November 30, 2006,
the Company elected under FIN No. 39 to net the payable or receivable
relating to the fair value of cash collateral received or paid associated
with its derivatives inventory in financial instruments owned and
financial instruments sold, but not yet purchased. See Note 1 of Notes to
the Consolidated Financial Statements for a complete discussion of cash
collateral netting. Exchange-traded financial instruments, such as futures
and options, generally do not give rise to significant unsecured
counterparty exposure due to the Company's margin requirements, which may
be greater than those prescribed by the individual exchanges. Options
written generally do not give rise to counterparty credit risk since they
obligate the Company (not its counterparty) to perform.
The Company has controls in place to monitor credit exposures by assessing
the future creditworthiness of counterparties and limiting transactions
with specific counterparties. The Company also seeks to control credit
risk by following an established credit approval process, monitoring
credit limits and requiring collateral where appropriate.
NON-TRADING DERIVATIVES ACTIVITY
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued US dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
interest payments. In addition, for foreign currency debt obligations that
are not used to fund assets in the same currency, the Company has entered
into currency swap agreements that effectively convert the debt into US
dollar obligations. Such transactions are accounted for as fair value
hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's
market-making and trading activities. The Company has similar controls in
place to monitor these risks. Interest rate swap agreements increased
interest expense on the Company's long- and short-term debt obligations by
$376.1 million during the fiscal year ended November 30, 2006 and reduced
interest expense on the Company's long- and short-term debt obligations by
$115.4 million and $589.3 million during the fiscal years ended November
30, 2005 and 2004, respectively.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether stand-alone or
embedded within other contracts or securities (except in very
93
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
defined circumstances) be carried on the Company's Statement of Financial
Condition at fair value. SFAS No. 133 also requires items designated as
being fair value hedged to be recorded at fair value, as defined in SFAS
No. 133, provided that the intent to hedge is fully documented. Any
resultant net change in value for both the hedging derivative and the
hedged item is recognized in earnings immediately, such net effect being
deemed the "ineffective" portion of the hedge. The gains and losses
associated with the ineffective portion of the fair value hedges are
included in "Principal Transactions" revenues in the Consolidated
Statements of Income. These amounts were immaterial for fiscal 2006, 2005
and 2004.
5. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
SECURITIZATIONS
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at November 30, 2006 and 2005
was approximately 150 days and 90 days, respectively. These retained
interests are included in "Financial Instruments Owned" in the
Consolidated Statements of Financial Condition and are carried at fair
value. Consistent with the valuation of similar inventory, fair value is
determined by broker-dealer price quotations and internal valuation
pricing models that utilize variables such as yield curves, prepayment
speeds, default rates, loss severity, interest rate volatilities and
spreads. The assumptions used for pricing variables are based on
observable transactions in similar securities and are further verified by
external pricing sources, when available.
The Company's securitization activities are detailed below:
Other
Agency Mortgage-
Mortgage- and Asset-
Backed Backed Total
--------------------------------------------------------------------------
(in billions)
--------------------------------------------------------------------------
Total securitizations
Fiscal 2006 $ 21.8 $ 99.3 $ 121.1
Fiscal 2005 $ 26.2 $ 89.8 $ 116.0
Retained interests
As of November 30, 2006 $ 1.5 $ 4.1 $ 5.6(1)
As of November 30, 2005 $ 1.8 $ 3.7 $ 5.5(2)
--------------------------------------------------------------------------
(1) Includes approximately $4.3 billion in investment-grade retained
interests, of which $3.0 billion is AAA rated.
(2) Includes approximately $4.7 billion in investment-grade retained
interests, of which $3.9 billion is AAA rated.
94
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the fiscal years ended
November 30, 2006 and 2005:
Other
Agency Mortgage-
Mortgage- and Asset-
Backed Backed Total
--------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------
Cash flows received
from retained interests
Fiscal 2006 $295.8 $760.3 $1,056.1
Fiscal 2005 $452.9 $498.0 $ 950.9
Cash flows from servicing
Fiscal 2006 $ 0.1 $ 89.5 $ 89.6
Fiscal 2005 $ 1.7 $ 68.8 $ 70.5
--------------------------------------------------------------------------
The Company is an active market maker in these securities and therefore
may retain interests in assets it securitizes, predominantly highly rated
or government agency-backed securities. The models employed in the
valuation of retained interests use discount rates that are based on the
Treasury yield curve plus a spread. Key points on the constant maturity
Treasury curve at November 30, 2006 were 4.59% for 2-year Treasuries and
4.52% for 10-year Treasuries, and ranged from 4.41% to 5.01%. These models
also consider prepayment speeds and credit losses. Credit losses are
calculated using option-adjusted spreads that also incorporate additional
factors such as liquidity and optionality.
Weighted average key economic assumptions used in measuring the fair value
of retained interests in assets the Company securitized at November 30,
2006 were as follows:
Agency Other Mortgage-
Mortgage- and Asset-
Backed Backed
--------------------------------------------------------------------------
Weighted average life (years) 6.7 4.7
Average prepayment speeds (annual rate) 8% - 45% 8% - 65%
Credit losses - 0% - 9%
--------------------------------------------------------------------------
The following hypothetical sensitivity analysis as of November 30, 2006
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve.
This shift considers the effect of other variables, including prepayments.
The remaining valuation assumptions are changed independently. Retained
interests in securitizations are generally not held to maturity and are
typically sold shortly after the settlement of a securitization. The
Company considers the current and expected credit profile of the
underlying collateral in determining the fair value and periodically
updates the fair value for changes in credit, interest rate, prepayment
speeds and other pertinent market factors. Actual credit losses on
retained interests have not been significant.
95
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
Agency Other Mortgage-
Mortgage- and Asset-
Backed Backed
--------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (35.9) $ (111.0)
Impact of 100 basis point adverse change (74.4) (227.2)
--------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (7.1) (66.4)
Impact of 20% adverse change (12.9) (90.8)
--------------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (3.8) (106.1)
Impact of 20% adverse change (7.6) (188.4)
--------------------------------------------------------------------------
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs. At
November 30, 2006, the key economic assumptions and the sensitivity of the
current fair value of MSRs to immediate changes in those assumptions were
as follows:
Fixed-Rate Adjustable-Rate
Sub-Prime Prime Prime & Alt-A
Loans & Alt-A Loans Loans
--------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------
Fair value of MSRs $ 153.0 $ 101.8 $ 250.1
Constant prepayment
rate (in CPR) 19% - 38% 13% - 42% 32% - 52%
Impact on fair value of:
5 CPR adverse change $ (11.1) $ (9.8) $ (19.7)
10 CPR adverse change (20.4) (14.5) (30.7)
Discount rate 15% 12% 13%
Impact on fair value of:
5% adverse change $ (14.1) $ (8.7) $ (14.8)
10% adverse change (23.1) (15.3) (25.6)
--------------------------------------------------------------------------
The previous tables should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the tables. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the tables do not consider the change in fair value
of hedging positions, which would generally offset the changes detailed in
the tables, nor do they consider any corrective action that the Company
may take in response to changes in these conditions. The impact of hedges
is not presented because hedging positions are established on a portfolio
level and allocating the impact would not be practicable.
96
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
MSRs are included in "Other Assets" on the Consolidated Statements of
Financial Condition. The Company's MSR activities for the fiscal years
ended November 30, 2006 and 2005 were as follows:
2006 2005
--------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------
Balance, beginning of year $ 431.1 $ 230.2
Additions 366.0 384.1
Sales, net (109.3) (47.1)
Amortization (187.5) (159.2)
Recovery 1.7 23.1
--------------------------------------------------------------------------
Balance, end of year $ 502.0 $ 431.1
==========================================================================
Changes in the MSR valuation allowance for the fiscal years ended November
30, 2006 and 2005 were as follows:
2006 2005
--------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------
Balance, beginning of year $ (10.6) $ (33.7)
Recovery 1.7 23.1
--------------------------------------------------------------------------
Balance, end of year $ (8.9) $ (10.6)
==========================================================================
6. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be VIEs.
These entities are an essential part of its securitization, asset
management and structured finance businesses. In addition, the Company
purchases and sells financial instruments that may be variable interests.
The Company adopted FIN No. 46 (R) for its variable interests in fiscal
2004. The Company consolidates those VIEs in which the Company is the
primary beneficiary.
The Company may perform various functions, including acting as the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company could be determined to be the primary
beneficiary through its ownership of certain beneficial interests, and
would, therefore, be required to consolidate the assets and liabilities of
the VIE.
The Company has a limited number of mortgage securitizations that did not
meet the criteria for sale treatment under SFAS No. 140. As such, the
Company continues to carry the assets and liabilities from these
transactions on its Consolidated Statements of Financial Condition.
Additionally, the Company retains call options on a limited number of
securitization transactions that require the Company to continue
recognizing the assets subject to the call options.
The Company also acts as portfolio manager and/or underwriter in several
collateralized debt obligation transactions. In these transactions, the
Company establishes a trust that purchases a portfolio of assets and
issues trust certificates that represent interests in the portfolio of
assets. In addition, the Company may receive variable compensation for
managing the portfolio and may also retain certain trust certificates. In
certain of these transactions, these interests result in the Company
becoming the primary beneficiary of these entities. The holders of the
trust certificates have recourse only to the underlying assets of the
trusts and not to other assets of the Company.
The Company establishes and operates funds for the benefit of its
employees. These funds are considered to be VIEs of which the Company is
the primary beneficiary.
97
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
Additionally, the Company invests in certain distressed debt instruments
in which the issuer is a VIE. The Company has determined that it is the
primary beneficiary of the VIE.
The following table sets forth the Company's total assets and maximum
exposure to loss associated with its significant variable interests in
consolidated VIEs and securitizations that did not qualify for sale
treatment. This information is presented based on principal business
activity, as reflected in the first column.
As of November 30, 2006 As of November 30, 2005
-------------------------------------------------------------------------------------------
Maximum Maximum
Exposure Exposure
(in millions) VIE Assets to Loss (1) VIE Assets to Loss (1)
-------------------------------------------------------------------------------------------
Mortgage Securitizations $ 16,798.1 $ 762.0 $ 5,296.1 $ 299.4
Call Options on Securitizations 12,186.2 - 8,697.4 -
Collateralized Debt Obligations 685.0 47.9 409.7 4.1
Employee Funds 575.1 355.0 748.5 526.9
Distressed Debt 58.9 58.8 - -
-------------------------------------------------------------------------------------------
Total $ 30,303.3 $ 1,223.7 $ 15,151.7 $ 830.4
===========================================================================================
(1) Represents the fair value of the Company's interest in these entities
and is reflected on the Consolidated Statements of Financial Condition.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations for which the Company is not
the primary beneficiary and therefore does not consolidate these entities.
In aggregate, these VIEs have assets approximating $14.8 billion and $4.7
billion at November 30, 2006 and 2005, respectively. At November 30, 2006
and 2005, the Company's maximum exposure to loss from these entities
approximates $163.2 million and $29.6 million, respectively, which
represents the fair value of its interests and is reflected in the
Consolidated Statements of Financial Condition.
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated or deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be held by the Company in future periods.
7. COLLATERALIZED FINANCING ARRANGEMENTS
The Company enters into secured borrowing and lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is also permitted by contract or custom to
rehypothecate securities received as collateral. These securities may be
used to secure repurchase agreements, enter into securities lending or
derivative transactions or cover short positions.
At November 30, 2006 and 2005, the fair value of securities received as
collateral by the Company that can be repledged, delivered or otherwise
used was approximately $286.06 billion and $254.62 billion, respectively.
Of these securities received as collateral, those with a fair value of
approximately $189.54 billion and $184.25 billion were delivered or
repledged at November 30, 2006 and 2005, respectively.
98
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
Instruments Owned and Pledged as Collateral, at Fair Value" in the
Consolidated Statements of Financial Condition. The carrying value of
securities and other inventory positions owned that have been pledged or
otherwise encumbered to counterparties where those counterparties do not
have the right to sell or repledge was approximately $41.58 billion and
$20.83 billion at November 30, 2006 and 2005, respectively.
8. SHORT-TERM BORROWINGS
The Company obtains short-term borrowings through the issuance of
commercial paper and bank loans and other borrowings. The interest rates
on such short-term borrowings reflect market rates of interest at the time
of the transactions.
The Company's short-term borrowings at November 30, 2006 and 2005
consisted of the following:
2006 2005
--------------------------------------------------------------------------
(in thousands)
--------------------------------------------------------------------------
Commercial paper $ 20,713,958 $ 9,675,903
Bank loans and other borrowings(1) 8,348,756 10,339,824
--------------------------------------------------------------------------
Total short-term borrowings $ 29,062,714 $ 20,015,727
==========================================================================
(1) Included in bank loans and other borrowings at November 30, 2006 and
2005 were secured borrowings of $3.28 billion and $258.9 million,
respectively.
The effective weighted average interest rates for short-term borrowings
were as follows:
Fiscal Years
As of November 30, Ended November 30,
------------------ ---------------------
2006 2005 2006 2005 2004
--------------------------------------------------------------------------
Commercial paper 5.25% 4.11% 4.92% 3.28% 1.32%
Bank loans and other borrowings 5.23% 4.16% 4.74% 3.33% 1.63%
--------------------------------------------------------------------------
Committed Credit Facilities
---------------------------
The Company has a committed revolving credit facility ("Facility")
totaling $4.0 billion, which permits borrowing on a secured basis by the
Parent Company, BSSC, BSIL and certain other subsidiaries. The Facility
also allows the Parent Company and BSIL to borrow up to $2.0 billion of
the Facility on an unsecured basis. Secured borrowings can be
collateralized by both investment-grade and non-investment-grade financial
instruments as the Facility provides for defined advance rates on a wide
range of financial instruments eligible to be pledged. The Facility
contains financial covenants, the most significant of which require
maintenance of specified levels of stockholders' equity of the Company and
net capital of BSSC. In February 2007, the Company renewed the Facility
with similar terms. The Facility now allows the Parent Company, BSIL, and
Bear Stearns International Trading Limited ("BSIT") to borrow up to $4.0
billion of the Facility on an unsecured basis. The Facility terminates in
February 2008, with all loans outstanding at that date payable no later
than February 2009. There were no borrowings outstanding under the
Facility at November 30, 2006.
The Company has a $1.50 billion committed revolving securities repo
facility ("Repo Facility"), which permits borrowings secured by a broad
range of collateral under a repurchase arrangement by the Parent Company,
BSIL, BSIT and BSB. The Repo Facility contains financial covenants that
require, among other things, maintenance of specified levels of
stockholders' equity of the Company. The Repo Facility terminates in
August 2007, with all repos outstanding at that date payable no later than
August 2008. There were no borrowings outstanding under the Repo Facility
at November 30, 2006.
99
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The Company has a $350 million committed revolving credit facility ("Pan
Asian Facility"), which permits borrowing on a secured basis by the Parent
Company, BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan
Asian Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the
Company and net capital of BSSC. In December 2006, the Company renewed the
Facility at a $350 million committed level with substantially the same
terms. The Pan Asian Facility terminates in December 2007 with all loans
outstanding at that date payable no later than December 2008. There were
no borrowings outstanding under the Pan Asian Facility at November 30,
2006.
The Company has a $350 million committed revolving credit facility ("Tax
Lien Facility"), which permits borrowing on a secured basis by the Parent
Company, Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax
Lien Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the
Company. The Tax Lien Facility terminates in March 2007 with all loans
outstanding at that date payable no later than March 2008. There were no
borrowings outstanding under the Tax Lien Facility at November 30, 2006.
The Company also maintains a series of committed credit facilities, which
permit borrowing on a secured basis, to support liquidity needs for the
financing of investment-grade and non-investment-grade corporate loans,
residential mortgages, commercial mortgages, listed options and whole
loans. The facilities are expected to be drawn from time to time and
expire at various dates, the longest of such periods ending in fiscal
2007. All of these facilities contain a term-out option of one year or
more for borrowings outstanding at expiration. The banks providing these
facilities are committed to provide up to an aggregate of approximately
$4.5 billion. At November 30, 2006, the borrowings outstanding under these
committed credit facilities were $90.1 million.
100
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
9. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at November 30, 2006 and 2005 consisted of the following:
2006 2005
--------------------------------------------------------------------------
(in thousands)
--------------------------------------------------------------------------
Fixed-rate notes due 2007 to 2036:
US dollar-denominated(1)(2) $ 15,243,336 $ 16,641,197
Non-US dollar-denominated 7,273,409 5,331,974
Floating-rate notes due 2007 to 2046:
US dollar-denominated 16,530,680 10,317,812
Non-US dollar-denominated 6,697,114 3,890,974
Index/equity/credit-linked notes:
US dollar-denominated 2,812,759 1,999,226
Non-US dollar-denominated 6,012,618 5,308,433
--------------------------------------------------------------------------
Total long-term borrowings $ 54,569,916 $ 43,489,616
==========================================================================
Amounts include fair value adjustments in accordance with SFAS No. 133.
(1) At November 30, 2006, US dollar-denominated fixed-rate notes were at
interest rates ranging from 1.0% to 7.5%.
(2) Included in US dollar-denominated fixed rate notes at November 30,
2006 were $1.0 billion of Subordinated Global Notes due January 22, 2017
that have an annual interest rate of 5.5%, which rank junior in right of
payment to all of the Company's senior indebtedness.
The Company has entered into interest rate swaps and other transactions to
convert its fixed-rate notes into floating rates based on LIBOR. For
floating-rate notes that are not based on LIBOR, the Company has generally
entered into interest rate swaps and other transactions to convert them
into floating rates based on LIBOR. Index/equity-linked borrowings include
various structured instruments whose payments and redemption values are
linked to the performance of a specific index (e.g., Dow Jones Industrial
Average), a basket of stocks or a specific equity security. To minimize
the exposure resulting from movements in the underlying equity position or
index, the Company has entered into various equity swap contracts.
Credit-linked notes include various structured instruments whose payments
and redemption values are linked to the performance of a basket of credit
products, an index or an individual security. To minimize exposure to
these instruments, the Company has entered into swaps that pay the
performance of the underlying security or index.
The effective weighted average interest rates for long-term borrowings,
after giving effect to the swaps, were as follows:
Fiscal Year
As of November 30, Ended November 30,
------------------ ------------------
2006 2005 2006 2005
---------------------------------------------------------------------
Fixed-rate notes 5.77% 4.61% 5.47% 3.59%
Floating-rate notes 5.50% 4.44% 5.19% 3.56%
---------------------------------------------------------------------
101
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The Company's long-term borrowings at November 30, 2006 mature as follows:
----------------------------------------------------------------------------------------
US Dollar Non-US Dollar
----------------------------------------------------------------------------------------
Index/ Index/
Equity/ Equity/
Fixed Floating Credit Fixed Floating Credit
Rate Rate Linked Rate Rate Linked Total
----------------------------------------------------------------------------------------
(in millions)
----------------------------------------------------------------------------------------
FISCAL YEAR
2007 $ 2,987 $ 2,192 $ 565 $ 225 $ 1 $ 514 $ 6,484
2008 2,380 6,283 991 351 232 755 10,992
2009 916 3,216 316 941 1,986 1,165 8,540
2010 2,320 1,238 325 1,531 340 830 6,584
2011 901 2,514 444 1,205 235 1,513 6,812
Thereafter 5,739 1,088 172 3,020 3,903 1,236 15,158
----------------------------------------------------------------------------------------
Total $ 15,243 $ 16,531 $ 2,813 $ 7,273 $ 6,697 $ 6,013 $ 54,570
========================================================================================
Amounts include fair value adjustments in accordance with SFAS No. 133 as
well as $262.5 million of junior subordinated deferrable interest
debentures ("Debentures"). The Debentures will mature on May 15, 2031;
however, effective May 15, 2006, the Company, at its option, may redeem
the Debentures. The Debentures are reflected in the table at their
contractual maturity date.
Included in fiscal 2008 are approximately $3.30 billion of floating-rate
notes that are redeemable prior to maturity at the option of the
noteholder. These notes contain certain provisions that effectively enable
noteholders to put these notes back to the Company and, therefore, are
reflected in the table under fiscal 2008 at the date such notes first
become redeemable. The final maturity dates of these notes are during
fiscal 2009, 2010 and 2011.
Instruments governing certain indebtedness of the Company contain various
financial covenants, including maintenance of minimum levels of
stockholders' equity of the Company. At November 30, 2006, the Company was
in compliance with all covenants contained in these debt agreements.
10. PREFERRED STOCK
PREFERRED STOCK ISSUED BY THE BEAR STEARNS COMPANIES INC.
The Company is authorized to issue a total of 10 million shares of
preferred stock at par value of $1.00 per share. At November 30, 2006, the
Company has 1,795,782 shares issued and outstanding under various series
as described below. All preferred stock has a dividend preference over the
Company's common stock in the paying of dividends and a preference in the
liquidation of assets.
The Company has outstanding 3,348,252 depositary shares representing
837,063 shares of Cumulative Preferred Stock, Series E ("Series E
Preferred Stock"), having an aggregate liquidation preference of $167.4
million as of November 30, 2006. Each depositary share represents a
one-fourth interest in a share of Series E Preferred Stock. Dividends on
the Series E Preferred Stock are payable at an annual rate of 6.15%.
Series E Preferred Stock is redeemable at the option of the Company at any
time on or after January 15, 2008, in whole or in part, at a redemption
price of $200 per share (equivalent to $50 per depositary share), plus
accrued but unpaid dividends to the redemption date. During the fiscal
year ended November 30, 2006, the Company redeemed and retired 145,000
depositary shares.
The Company has outstanding 1,790,200 depositary shares representing
447,550 shares of Cumulative Preferred Stock, Series F ("Series F
Preferred Stock"), having an aggregate liquidation preference of $89.5
million as of November 30, 2006. Each depositary share represents a
one-fourth interest in a share of Series F Preferred Stock. Dividends on
the Series F Preferred Stock are payable at an annual rate of 5.72%.
Series F Preferred Stock is redeemable at the option of the Company at any
time on or after April 15, 2008, in whole or in part, at a redemption
price of $200 per share (equivalent to $50 per depositary share), plus
accrued but unpaid dividends to the redemption date. During the fiscal
year ended November 30, 2006, the Company redeemed and retired 91,500
depositary shares.
102
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The Company has outstanding 2,044,675 depositary shares representing
511,169 shares of Cumulative Preferred Stock, Series G ("Series G
Preferred Stock"), having an aggregate liquidation preference of $102.2
million as of November 30, 2006. Each depositary share represents a
one-fourth interest in a share of Series G Preferred Stock. Dividends on
the Series G Preferred Stock are payable at an annual rate of 5.49%.
Series G Preferred Stock is redeemable at the option of the Company at any
time on or after July 15, 2008, in whole or in part, at a redemption price
of $200 per share (equivalent to $50 per depositary share), plus accrued
but unpaid dividends to the redemption date. During the fiscal year ended
November 30, 2006, the Company redeemed and retired 26,900 depositary
shares.
PREFERRED STOCK ISSUED BY SUBSIDIARIES
Bear Stearns Capital Trust III ("Capital Trust III"), a wholly owned
subsidiary of the Company, has issued $262.5 million (10,500,000 shares)
of Guaranteed Preferred Beneficial Interests in Company Subordinated Debt
Securities ("Preferred Securities"). The Preferred Securities are
fixed-rate securities, which have a liquidation value of $25 per security.
Holders of the Preferred Securities are entitled to receive quarterly
preferential cash distributions at an annual rate of 7.8% through May 15,
2031. The proceeds of the issuance of the Preferred Securities were used
to acquire junior subordinated deferrable interest debentures
("Debentures") issued by the Company. The Debentures have terms that
correspond to the terms of the Preferred Securities and are the sole
assets of Capital Trust III. The Preferred Securities will mature on May
15, 2031. Effective May 15, 2006, the Company, at its option, may redeem
the Preferred Securities at their principal amounts plus accrued
distributions.
In accordance with FIN No. 46 (R), the Company has deconsolidated Capital
Trust III. As a result, the Debentures issued by the Company to Capital
Trust III are included within long-term borrowings at November 30, 2006
and 2005. The $262.5 million of Preferred Securities issued by Capital
Trust III are still outstanding, providing the funding for such
Debentures. The Preferred Securities issued by Capital Trust III are no
longer included in the Company's Consolidated Statements of Financial
Condition.
103
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
11. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the CAP Plan, as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock compensation plans, which will be
distributed as shares of common stock. Diluted EPS includes the
determinants of Basic EPS and, in addition, gives effect to dilutive
potential common shares related to stock compensation plans.
The computations of Basic and Diluted EPS for the fiscal years ended
November 30, 2006, 2005 and 2004 are set forth below:
2006 2005 2004
------------------------------------------------------------------------------------------------------
(in thousands, except per share amounts)
------------------------------------------------------------------------------------------------------
Net income $ 2,053,871 $ 1,462,177 $ 1,344,733
Preferred stock dividends (21,363) (24,321) (28,072)
Redemption of preferred stock 55 - 1,230
Income adjustment (net of tax) applicable to
deferred compensation arrangements--vested shares 46,947 50,630 69,518
------------------------------------------------------------------------------------------------------
Net earnings used for Basic EPS 2,079,510 1,488,486 1,387,409
Income adjustment (net of tax) applicable to deferred
compensation arrangements--non-vested shares 41,017 31,622 31,011
------------------------------------------------------------------------------------------------------
Net earnings used for Diluted EPS $ 2,120,527 $ 1,520,108 $ 1,418,420
======================================================================================================
Total basic weighted average common shares outstanding(1) 131,711 130,327 127,468
------------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 5,948 4,064 3,604
CAP and restricted units 10,916 13,077 14,213
------------------------------------------------------------------------------------------------------
Dilutive potential common shares 16,864 17,141 17,817
------------------------------------------------------------------------------------------------------
Weighted average number of common shares
outstanding and dilutive potential common shares 148,575 147,468 145,285
======================================================================================================
Basic EPS $ 15.79 $ 11.42 $ 10.88
Diluted EPS $ 14.27 $ 10.31 $ 9.76
======================================================================================================
(1) Includes 12.7 million, 18.1 million and 24.6 million vested units for
the fiscal years ended November 30, 2006, 2005 and 2004, respectively,
issued under certain employee stock compensation plans, which will be
distributed as shares of common stock.
12. EMPLOYEE BENEFIT PLAN
The Company has a qualified non-contributory profit sharing plan covering
substantially all employees. Contributions are made at the discretion of
management in amounts that relate to the Company's level of income before
provision for income taxes. The Company's expense related to the profit
sharing plan for the fiscal years ended November 30, 2006, 2005 and 2004
was $45.0 million, $37.0 million and $26.0 million, respectively.
13. STOCK COMPENSATION PLANS
The Company has various stock compensation plans designed to increase the
emphasis on stock-based incentive compensation and align the compensation
of its key employees with the long-term interests of stockholders. As
discussed in Note 1, "Summary of Significant Accounting Policies,"
effective December 1, 2005, the Company adopted SFAS No. 123 (R) using the
modified prospective application method. Stock-based compensation cost is
measured at grant date, based on the fair value of the award and is
recognized as expense over the requisite service period. The compensation
cost that has been charged against income for the Company's stock
compensation plans was $847.9 million, $649.7 million and $588.2 million
for the fiscal years ended November 30, 2006, 2005 and 2004,
104
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
respectively. The total income tax benefit recognized in the income
statement for stock-based compensation arrangements was $356.7 million,
$273.3 million and $247.4 million for fiscal years ended November 30,
2006, 2005 and 2004, respectively.
The Company concluded that under SFAS No. 123 (R), the grant date for
stock-based compensation awards is the date the awards are approved by the
Company's Compensation Committee. The Compensation Committee approved the
2006 stock-based compensation awards in December 2006. In prior years,
stock-based compensation granted in December was included in stockholders'
equity at November year end. The Company's stock-based compensation plans
are summarized below.
STOCK REPURCHASE PROGRAM
The Company intends to offset the potentially dilutive impact of the
annual grants by purchasing common stock throughout the year in open
market and private transactions. On December 13, 2006, the Board of
Directors of the Company approved an amendment to the Stock Repurchase
Program to replenish the previous authorization in order to allow the
Company to purchase up to $2.0 billion of common stock in fiscal 2007 and
beyond. The Company expects to utilize the repurchase authorization to
offset the dilutive impact of annual share awards. The Company may,
depending upon price and other factors, repurchase additional shares in
excess of that required for annual share awards. In addition, on December
12, 2006, the Compensation Committee of the Board of Directors of the
Company approved an amendment to the CAP Plan Earnings Purchase
Authorization to replenish the previous authorization in order to allow
the Company to purchase up to $200 million of common stock in fiscal 2007.
The Company's policy is to issue shares out of treasury upon share option
exercise or share unit conversion.
CAPITAL ACCUMULATION PLAN
Pursuant to the CAP Plan, certain key executives receive a portion of
their total annual compensation in the form of CAP units. The number of
CAP units credited is a function of the dollar amount awarded to each
participant and the closing fair market value of the Company's common
stock on the date of the award. The CAP units awarded under the CAP Plan
are generally subject to vesting and convert to common stock after five
years. Holders of CAP units generally may forfeit ownership of a portion
of their award if employment is terminated before the end of the vesting
period. The total number of CAP units that may be issued under the CAP
Plan during any fiscal year may not exceed 15% of the sum of issued and
outstanding shares of common stock and CAP units outstanding determined as
of the last day of the current fiscal year.
Each CAP unit gives the participant an unsecured right to receive, on an
annual basis, an amount equal to the Company's pre-tax income per share,
as defined by the CAP Plan, less net income per share, as defined by the
CAP Plan, plus dividends per share ("earnings adjustment"), subject to
certain limitations. The earnings adjustment will be credited to each
participant's deferred compensation account in the form of additional CAP
units, based on the number of CAP units in such account at the end of each
fiscal year. The number of CAP units credited depends on the amount
awarded to each participant and the average per share cost of common stock
acquired by the Company. On completion of the five-year deferral period,
participants are entitled to receive shares of common stock equal to the
number of CAP units then credited to their respective deferred
compensation accounts. Amounts recognized attributable to CAP units with
respect to the earnings adjustment are recorded in "Other Expenses" in the
Consolidated Statements of Income.
The majority of stock-based compensation expense for the years ended
November 30, 2006, 2005 and 2004 was generated from the grant of CAP
units. During the fiscal years ended November 30, 2006, 2005 and 2004, the
Company expensed $544.9 million, $363.4 million and $330.9 million,
respectively, attributable to CAP units granted to participants for each
of those years. In addition, during the fiscal years ended November 30,
2006, 2005 and 2004, the Company recognized expense of $154.0 million,
$144.0 million and $176.0 million, respectively, attributable to CAP units
with respect to the earnings adjustment. Awards allocated pursuant to the
CAP Plan are credited to
105
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
participants' deferred compensation accounts in the form of CAP units and
are included in stockholders' equity. At November 30, 2006, $544.9 million
accrued for CAP units was included in Accrued Employee Compensation and
Benefits on the Consolidated Statement of Financial Condition and not in
stockholders' equity. During the fiscal years ended November 30, 2006,
2005 and 2004, the Company recognized total compensation expense, net of
forfeitures, related to the CAP plan, of $527.6 million, $353.2 million
and $322.2 million, respectively.
RESTRICTED STOCK UNIT PLAN
The Restricted Stock Unit Plan ("RSU Plan") provides for a portion of
certain key employees' compensation to be granted in the form of
restricted stock units ("RSUs"), with allocations made to participants'
deferred compensation accounts. Under the RSU Plan, RSUs granted to
employees have various vesting provisions and generally convert to common
stock within four years. Such units are restricted from sale, transfer or
assignment until the end of the restriction period. Holders of RSUs
generally may forfeit ownership of a portion of their award if employment
is terminated before the end of the vesting period. Holders of RSUs are
entitled to receive a dividend in the form of additional RSUs, based on
dividends declared on the Company's common stock. The total number of RSUs
that may be granted under the RSU Plan may not exceed 15,000,000. As of
November 30, 2006, the total number of RSUs outstanding was 6,953,340.
The Company measures compensation cost for RSUs based on the fair market
value of its common stock at the award date. A portion related to current
service is expensed in the year of the award and that portion relating to
future service is amortized over the vesting period. Amounts awarded and
deferred pursuant to the RSU Plan and the unamortized portion of these
amounts are shown as separate components of stockholders' equity. During
the fiscal years ended November 30, 2006, 2005 and 2004, the Company
recognized compensation expense of $201.2 million, $135.4 million and
$119.1 million, respectively, related to awards granted to participants in
each of those years. At November 30, 2006, $190.4 million accrued for RSUs
was included in Accrued Employee Compensation and Benefits and not in
stockholders' equity. During the fiscal years ended November 30, 2006,
2005 and 2004, the Company recognized total compensation expense related
to the RSU Plan of $218.0 million, $173.9 million and $167.4 million,
respectively.
As of November 30, 2006, there was $155.6 million of total unrecognized
compensation cost related to stock-based compensation granted under the
RSU Plan which is expected to be recognized over a weighted average period
of approximately three years. In addition, $46.6 million in unearned
compensation granted in December 2006 in connection with fiscal 2006
awards was not reflected in stockholders' equity as of November 30, 2006
and is expected to be recognized over a weighted average period of four
years.
STOCK AWARD PLAN
Pursuant to the Stock Award Plan, certain key employees are given the
opportunity to acquire common stock through the grant of options. Stock
options generally have a 10-year expiration. The total number of stock
options that may be issued under the Stock Award Plan may not exceed
40,000,000. As of November 30, 2006, the total number of stock options
outstanding was 19,721,603.
The Company awarded approximately $89 million, $108 million and $110
million of employee stock options in fiscal 2006, 2005 and 2004,
respectively, of which approximately $89 million, $99 million and $90
million were expensed in fiscal 2006, 2005 and 2004, respectively. The $89
million expensed in fiscal 2006 includes grants with a vesting period that
under SFAS No. 123 (R) are required to be expensed for employees who are
retirement eligible. Unvested awards granted in prior years are expensed
over the future vesting periods, generally over three years. As of
November 30, 2006, $87 million accrued for stock option awards was
included in Accrued Employee Compensation and Benefits in the Consolidated
Statement of Financial Condition and not in stockholders' equity. In
fiscal 2006, 2005 and 2004,
106
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
the Company recognized total compensation expense related to stock options
of $102.3 million, $122.6 million and $98.6 million, respectively.
Fair value was estimated at grant date based on a modified Black-Scholes
option-pricing model. The weighted average fair value of options granted
relating to the fiscal years ended November 30, 2006, 2005 and 2004 was
$45.83, $26.50 and $26.00 per option, respectively. These amounts reflect
adjustments for vesting requirements and potential maturity shortening.
Estimates of fair value are not intended to predict the value ultimately
realized by employees who receive equity awards and subsequent events are
not indicative of the reasonableness of the original estimates of fair
value made by the Company.
The total intrinsic value of options exercised during the years ended
November 30, 2006, 2005 and 2004 was $246.8 million, $148.9 million and
$138.2 million, respectively. The total cash received from employees as a
result of stock option exercises for the years ended November 30, 2006,
2005 and 2004 was approximately $289.6 million, $201.9 million and $235.8
million, respectively. In connection with these exercises, the tax
benefits realized by the Company for the years ended November 30, 2006,
2005 and 2004 were $89.8 million, $59.4 million and $47.4 million,
respectively.
The following table highlights the assumptions used for the fiscal years
ended November 30:
2006 2005 2004
--------------------------------------------------------------------------
Risk-free interest rate(1) 4.57% 4.46% 4.24%
Expected option life(2) 5 years 5 years 5 years
Expected stock price volatility(3) 26% 21% 24%
Dividend yield 0.68% 0.90% 1.45%
--------------------------------------------------------------------------
(1) Represents the interest rate of the five-year US Treasury note.
(2) The expected option life is the number of years that the Company
estimates, based on history, that options will be outstanding prior to
exercise or forfeiture.
(3) The Company's estimates of expected volatility are principally based
on implied volatility of the Company's common stock and other relevant
factors.
NON-EMPLOYEE DIRECTORS' STOCK OPTION AND STOCK UNIT PLAN
Pursuant to the Non-Employee Directors' Stock Option and Stock Unit Plan
("Directors' Plan"), members of the Board of Directors of the Company who
are not employees of the Company or any of its subsidiaries ("Non-Employee
Directors") may be offered the opportunity to acquire common stock through
the grant of options and will receive common stock on the vesting of RSUs.
Non-Employee Directors may elect to exchange a portion of their annual
cash retainer paid by the Company for services rendered as a director, for
stock options or RSUs. Stock options and RSUs issued under the plan
generally vest six months after the date of issuance and stock options
have a 10-year expiration. The total number of stock options and RSUs
combined that may be issued under the Directors' Plan may not exceed
300,000. As of November 30, 2006, the total number of stock options and
RSUs outstanding was 118,778 and 23,248, respectively. During the fiscal
years ended November 30, 2006, 2005 and 2004, the Company recognized
expense of $2.3 million, $1.2 million and $0.7 million, respectively,
related to these awards.
107
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
SUMMARY OF ALL STOCK UNIT AND OPTION ACTIVITY
The following is a summary of CAP units and RSUs outstanding:
Weighted Average Weighted Average
CAP Units Fair Value RSUs Fair Value
-----------------------------------------------------------------------------------------------
Balance, November 30, 2005 25,823,714 $ 74.25 8,676,609(2) $ 80.07
Granted(1) 1,141,332 $134.93 707,400 $125.07
Forfeited (291,051) $110.60 (541,448) $102.25
Distributed (8,148,340) $ 53.58 (1,865,973) $ 61.50
-----------------------------------------------------------------------------------------------
Balance, November 30, 2006 18,525,655 $ 86.49 6,976,588 $ 87.63
===============================================================================================
(1) The weighted average grant-date fair value for CAP units and RSUs
combined was $132.01, $112.01 and $96.06 for fiscal years ended November
30, 2006, 2005 and 2004, respectively.
(2) Includes 208,907 RSUs outstanding as of November 30, 2005, which were
granted under a one-time award in fiscal 2000.
Note: In December 2006, the Company granted 3,295,999 and 1,151,572 CAP
units and RSUs, respectively, at an average market price of $165.32. In
addition, in December 2006, 2,672,408 and 1,482,189 CAP units and RSUs,
respectively, were converted into common shares and distributed to
participants. The award grants and distributions made in December 2006 are
not reflected in the table above.
Activity with respect to stock options for the fiscal year ended November
30, 2006 is presented below:
2006
Weighted
Average
Number of Exercise
Shares Price
-------------------------------------------------
Beginning balance 23,979,179 $ 77.31
Granted 58,410(1) $128.17
Exercised (4,001,211) $ 72.33
Forfeited (195,997) $ 84.22
---------------------------------------
Ending balance 19,840,381(2) $ 78.39
=============
(1) In December 2006, the Company granted 1,873,543 options to employees
with an exercise price of $165.32 and a fair value of $46.66. These option
grants are not reflected in the table above.
(2) At November 30, 2006, 17,727,439 stock options were exercisable with a
weighted average exercise price of $77.02 and had an average remaining
contractual life of 6.5 years. The aggregate intrinsic value for options
outstanding and options exercisable as of November 30, 2006 was $1.47
billion and $1.34 billion, respectively.
108
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
Information for the Company's stock options as of November 30, 2006 is
presented in the following table:
Options Outstanding
----------------------------------------------------
Average
Weighted Remaining
Range of Average Contractual
Exercise Number Exercise Life
Prices Outstanding Price (Years)
----------------------------------------------------
$35.00-$49.99 3,717,859 $ 47.01 3.8
$50.00-$64.99 5,096,175 $ 60.36 5.5
$65.00-$79.99 3,740,292 $ 73.72 7.0
$80.00-$94.99 27,348 $ 87.93 6.1
$95.00-$109.99 3,792,289 $ 102.62 8.1
$110.00-$124.99 3,410,758 $ 116.50 9.1
$125.00-$139.99 25,029 $ 135.73 9.0
$140.00-$201.99 30,631 $ 159.15 7.8
----------
Total 19,840,381 $ 78.39 6.6
==========
14. CUSTOMER ACTIVITIES
CUSTOMER CREDIT RISKS
The Company's clearance activities for both clearing clients and customers
(collectively, "customers"), involve the execution, settlement and
financing of customers' securities and futures transactions. Customers'
securities activities are transacted on either a cash or margin basis,
while customers' futures transactions are generally transacted on a margin
basis subject to exchange regulations.
In connection with the customer clearance activities, the Company executes
and clears customer transactions involving the sale of securities short
("short sales"), entering into futures transactions and the writing of
option contracts. Short sales require the Company to borrow securities to
settle customer short sale transactions and, as such, these transactions
may expose the Company to loss if customers are unable to fulfill their
contractual obligations and customers' collateral balances are
insufficient to fully cover their losses. In the event customers fail to
satisfy their obligations, the Company may be required to purchase
financial instruments at prevailing market prices in order to fulfill the
customers' obligations.
The Company seeks to control the risks associated with its customers'
activities by requiring customers to maintain margin collateral in
compliance with various regulatory and internal guidelines. The Company
monitors required margin levels and, pursuant to such guidelines, may
require customers to deposit additional cash or collateral, or to reduce
positions, when deemed necessary. The Company also establishes credit
limits for customers engaged in futures activities and monitors credit
compliance. Additionally, with respect to the Company's correspondent
clearing activities, introducing correspondent firms generally guarantee
the contractual obligations of their customers. Further, the Company seeks
to reduce credit risk by entering into netting agreements with customers,
which permit receivables and payables with such customers to be offset in
the event of a customer default.
In connection with the Company's customer financing and securities
settlement activities, the Company may pledge customers' securities as
collateral to satisfy the Company's exchange margin deposit requirements
or to support its various secured financing sources such as bank loans,
securities loaned and repurchase agreements. In the event counterparties
are unable to meet their contractual obligations to return customers'
securities pledged as collateral, the Company may be exposed to the risk
of acquiring the securities at prevailing market prices to satisfy its
obligations to such customers. The Company seeks to control this risk by
monitoring the market value of securities pledged and by
109
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
requiring adjustments of collateral levels in the event of excess
exposure. Moreover, the Company establishes credit limits for such
activities and monitors credit compliance.
CONCENTRATIONS OF CREDIT RISKS
The Company is engaged in providing securities processing services to a
diverse group of individuals and institutional investors, including
affiliates. A substantial portion of the Company's transactions is
collateralized and is executed with, or made on behalf of, institutional
investors, including other brokers and dealers, commercial banks,
insurance companies, pension plans, mutual funds, hedge funds and other
financial institutions. The Company's exposure to credit risk, associated
with the non-performance of customers in fulfilling their contractual
obligations pursuant to securities and futures transactions, can be
directly affected by volatile or illiquid trading markets, which may
impair customers' ability to satisfy their obligations to the Company. The
Company attempts to minimize credit risk associated with these activities
by monitoring customers' credit exposure and collateral values and
requiring, when deemed necessary, additional collateral to be deposited
with the Company.
A significant portion of the Company's securities processing activities
includes clearing transactions for hedge funds, brokers and dealers and
other professional traders, including affiliates. Due to the nature of
these operations, which may include significant levels of credit extension
such as leveraged purchases, short selling and option writing, the Company
may have significant credit exposure should these customers be unable to
meet their commitments. In addition, the Company may be subject to
concentration risk through providing margin to those customers holding
large positions in certain types of securities, securities of a single
issuer, including sovereign governments, issuers located in a particular
country or geographic area or issuers engaged in a particular industry,
where the Company receives such large positions as collateral. The Company
seeks to control these risks by monitoring margin collateral levels for
compliance with both regulatory and internal guidelines. Additional
collateral is obtained when necessary. To further control these risks, the
Company has developed automated risk control systems that analyze the
customers' sensitivity to major market movements. The Company will require
customers to deposit additional margin collateral, or to reduce positions
if it is determined that customers' activities may be subject to
above-normal market risk.
The Company acts as a clearing broker for substantially all of the
customer and proprietary securities and futures activities of its
affiliates on either a fully disclosed or omnibus basis. Such activities
are conducted on either a cash or margin basis. The Company requires its
affiliates to maintain margin collateral in compliance with various
regulatory guidelines. The Company monitors required margin levels and
requests additional collateral when deemed appropriate.
110
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
15. INCOME TAXES
The Company and certain of its subsidiaries file a US consolidated federal
income tax return. The provision for income taxes for the fiscal years
ended November 30, 2006, 2005 and 2004 consisted of the following:
2006 2005 2004
--------------------------------------------------------------
(in thousands)
--------------------------------------------------------------
CURRENT:
Federal $ 806,111 $ 448,843 $ 568,972
State and local 181,876 59,032 125,332
Foreign 190,097 124,070 65,692
--------------------------------------------------------------
Total current 1,178,084 631,945 759,996
--------------------------------------------------------------
DEFERRED:
Federal (47,153) 93,860 (28,519)
State and local (966) 35,247 (34,485)
Foreign (37,206) (16,170) (19,571)
--------------------------------------------------------------
Total deferred (85,325) 112,937 (82,575)
--------------------------------------------------------------
Total provision
for income taxes $ 1,092,759 $ 744,882 $ 677,421
==============================================================
As of November 30, 2006, the Company had approximately $1.28 billion in
accumulated earnings permanently reinvested overseas. If such income were
repatriated, additional federal income tax (net of available tax credits)
at current tax rates would be approximately $249 million.
Significant components of the Company's deferred tax assets (liabilities)
as of November 30, 2006 and 2005 were as follows:
2006 2005
--------------------------------------------------------------------------
(in thousands)
--------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Deferred compensation $ 1,213,138 $ 1,233,847
Liability reserves and valuation adjustments 108,380 168,274
Unrealized loss 19,501 18,869
Other 247,015 126,559
--------------------------------------------------------------------------
Total deferred tax assets 1,588,034 1,547,549
--------------------------------------------------------------------------
DEFERRED TAX LIABILITIES:
Unrealized appreciation (42,567) (123,341)
Depreciation/amortization (67,439) (45,893)
Other (47,076) (32,687)
--------------------------------------------------------------------------
Total deferred tax liabilities (157,082) (201,921)
--------------------------------------------------------------------------
Net deferred tax assets $ 1,430,952 $ 1,345,628
==========================================================================
At November 30, 2006 and 2005, no valuation allowance has been established
against deferred tax assets since it is more likely than not that the
deferred tax assets will be realized. Net deferred tax assets are included
in "Other Assets" in the Consolidated Statements of Financial Condition.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly assesses the likelihood of additional assessments in
each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as
111
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
information becomes available or when an event requiring a change to the
reserve occurs. The resolution of tax matters could have a material impact
on the Company's effective tax rate.
A reconciliation of the statutory federal income tax rates to the
Company's effective tax rates for the fiscal years ended November 30,
2006, 2005 and 2004 was as follows:
2006 2005 2004
-------------------------------------------------------
Statutory rate 35.0% 35.0% 35.0%
State and local income taxes,
net of federal benefit 3.7 2.7 2.9
Tax-exempt interest income
and dividend exclusion (1.1) (2.1) (2.3)
Domestic tax credits (0.4) (0.5) (0.5)
Other, net (2.5) (1.3) (1.6)
--------------------------------------------------------
Effective tax rate 34.7% 33.8% 33.5%
========================================================
Not included in the effective tax rate is the effect of approximately
$363.0 million, $426.1 million and $163.9 million in income tax benefits
attributable to the distribution of common stock under the CAP Plan and
other deferred compensation plans as well as the exercise of options,
credited directly to paid-in capital, for fiscal 2006, 2005 and 2004,
respectively.
16. REGULATORY REQUIREMENTS
Effective December 1, 2005, the Company became regulated by the Securities
and Exchange Commission ("SEC") as a consolidated supervised entity
("CSE"). As a CSE, the Company is subject to group-wide supervision and
examination by the SEC and is required to compute allowable capital and
allowances for market, credit and operational risk on a consolidated
basis. As of November 30, 2006, the Company was in compliance with the CSE
capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the
Securities Exchange Act of 1934 ("Net Capital Rule") and Rule 1.17 under
the Commodity Futures Trading Commission. Effective December 1, 2005, the
SEC approved Bear Stearns' use of Appendix E of the Net Capital Rule,
which establishes alternative net capital requirements for broker-dealers
that are part of consolidated supervised entities. Appendix E allows Bear
Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models, provided
that Bear Stearns holds tentative net capital in excess of $1 billion and
net capital in excess of $500 million. At November 30, 2006, Bear Stearns'
net capital of $4.03 billion exceeded the minimum requirement by $3.48
billion. Bear Stearns' net capital computation, as defined, includes
$768.7 million, which represents net capital of BSSC in excess of 5.5% of
aggregate debit items arising from customer transactions.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the United Kingdom's Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Financial Regulator.
Custodial Trust Company ("CTC"), a Federal Deposit Insurance Corporation
("FDIC") insured New Jersey state chartered bank, offers a range of trust,
lending and securities-clearance services. CTC provides the Company with
banking powers, including access to the securities and funds-wire services
of the Federal Reserve System. CTC is subject to the regulatory capital
requirements of the FDIC.
112
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
At November 30, 2006, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were in
compliance with their respective regulatory capital requirements. Certain
other subsidiaries are subject to various securities regulations and
capital adequacy requirements promulgated by the regulatory and exchange
authorities of the countries in which they operate. At November 30, 2006,
these other subsidiaries were in compliance with their applicable local
capital adequacy requirements.
Regulatory rules, as well as certain covenants contained in various
instruments governing indebtedness of the Company, Bear Stearns and other
regulated subsidiaries, may restrict the Company's ability to withdraw
capital from its regulated subsidiaries, which in turn could limit the
Company's ability to pay dividends. Also, the Company's broker-dealer
subsidiaries and other regulated subsidiaries are subject to minimum
capital requirements that may restrict the Company's ability to withdraw
capital from its regulated subsidiaries, which in turn could limit the
Company's ability to pay dividends. At November 30, 2006, approximately
$4.10 billion in equity capital of Bear Stearns, BSSC, BSIL, BSIT and BSB
was restricted as to the payment of cash dividends and advances to the
Company.
17. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
LEASES
The Company occupies office space under leases that expire at various
dates through 2024. At November 30, 2006, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years ended November 30,
2007 through 2011 and the aggregate amount thereafter, are as follows:
-----------------------
(in thousands)
-----------------------
FISCAL YEAR
2007 $ 97,791
2008 104,642
2009 98,887
2010 101,034
2011 103,202
Thereafter 597,356
-----------------------
The various leases contain provisions for periodic escalations resulting
from increased operating and other costs. Rental expense, including
escalations and net of sublease rental income, under these leases was
$164.1 million, $134.2 million and $111.4 million for the fiscal years
ended November 30, 2006, 2005 and 2004, respectively.
LENDING-RELATED COMMITMENTS
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment-grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment-grade borrowers
aggregated approximately $3.83 billion and $2.37 billion at November 30,
2006 and 2005, respectively. Of this amount, approximately $697.8 million
and $639.5 million was hedged at November 30, 2006 and 2005, respectively.
Lending-related commitments to non-investment-grade borrowers approximated
$2.04 billion and $1.44 billion at November 30, 2006 and 2005,
respectively. Of this amount, approximately $88.8 million and $13.0
million was hedged at November 30, 2006 and 2005, respectively.
113
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The Company also had contingent commitments to investment-grade and
non-investment-grade companies of approximately $17.48 billion and $3.89
billion as of November 30, 2006 and 2005, respectively. Generally, these
commitments are provided in connection with leveraged acquisitions. These
commitments are not indicative of the Company's actual risk because the
borrower may never draw upon the commitment. In fact, the borrower may not
be successful in the acquisition, the borrower may access the capital
markets instead of drawing on the commitment, or the Company's portion of
the commitment may be reduced through the syndication process.
Additionally, the borrower's ability to draw may be subject to there being
no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally
contain certain flexible pricing features to adjust for changing market
conditions prior to closing.
PRIVATE EQUITY-RELATED INVESTMENTS AND PARTNERSHIPS
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At November 30, 2006 and 2005, such
commitments aggregated $788.3 million and $222.1 million, respectively.
These commitments will be funded, if called, through the end of the
respective investment periods, with the longest of such periods ending in
2017.
UNDERWRITING
In connection with the Company's mortgage-backed securitizations and fixed
income underwriting, the Company had commitments to purchase new issues of
securities aggregating $205.0 million and $943.1 million, respectively, at
November 30, 2006 and 2005.
COMMERCIAL AND RESIDENTIAL LOANS
The Company participates in the origination, acquisition, securitization,
servicing, financing and disposition of commercial and residential loans.
At November 30, 2006 and 2005, the Company had entered into commitments to
purchase or finance commercial and residential loans of $4.23 billion and
$5.10 billion, respectively.
LETTERS OF CREDIT
At November 30, 2006 and 2005, the Company was contingently liable for
unsecured letters of credit of approximately $3.30 billion and $2.50
billion, respectively, and secured (by financial instruments) letters of
credit of $1.25 billion and $985.6 million, respectively. These letters of
credit are primarily used to provide collateral for securities borrowed
and to satisfy margin requirements at option and commodity exchanges.
OTHER
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $95.7 million and $159.8 million respectively, at November
30, 2006 and 2005.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
LITIGATION
The Company is the sole defendant in an action commenced in the United
States Bankruptcy court for the Southern District of New York by the
Chapter 11 Trustee for Manhattan Investment Fund Limited ("MIFL"). The
complaint seeks to recover from the Company, among other things, certain
allegedly fraudulent transfers made by MIFL in the amount of $141.4
million plus pre-judgment interest. The Company provided prime brokerage
services to MIFL prior
114
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
to its bankruptcy. In January 2007, the Bankruptcy Court granted the
Trustee's motion for summary judgment on the fraudulent transfer claims
against the Company. The Company believes it has substantial defenses to
the Trustee's claims and intends to appeal the decision of the Bankruptcy
Court.
In the normal course of business, the Company has been named as a
defendant in various legal actions, including arbitrations, class actions
and other litigation. Certain of the legal actions include claims for
substantial compensatory and/or punitive damages or claims for
indeterminate amounts of damages. The Company is also involved in other
reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of
which may result in adverse judgments, settlements, fines, penalties,
injunctions or other relief.
Because litigation is inherently unpredictable, particularly in cases
where claimants seek substantial or indeterminate damages or where
investigations and proceedings are in the early stages, the Company cannot
predict with certainty the loss or range of loss related to such matters,
how such matters will be resolved, when they will ultimately be resolved,
or what the eventual settlement, fine, penalty or other relief might be.
Consequently, the Company cannot estimate losses or ranges of losses for
matters where there is only a reasonable possibility that a loss may have
been incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after
consultation with counsel, that the resolution of the foregoing matters
will not have a material adverse effect on the financial condition of the
Company, taken as a whole; such resolution may, however, have a material
effect on the operating results in any future period, depending on the
level of income for such period.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies." The ultimate resolution may differ
materially from the amounts reserved.
18. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others" requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed party may not be based
on changes to an asset, liability or equity security of the guaranteed
party. In addition, FIN No. 45 covers certain indemnification agreements
that contingently require the guarantor to make payments to the
indemnified party, such as an adverse judgment in a lawsuit or the
imposition of additional taxes due to either a change in the tax law or an
adverse interpretation of the tax law.
115
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of November 30, 2006:
Amount of Guarantee Per Expiration Period
--------------------------------------------------------------------------
Less One Greater
Than to Three Three to Than Five
(in millions) One Year Years Five Years Years Total
--------------------------------------------------------------------------
Certain derivative
contracts (notional)(1) $481,172 $405,969 $583,718 $475,159 $1,946,018
Municipal securities 2,570 409 - - 2,979
Residual value guarantee - - 570 - 570
--------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $4.66 billion as
of November 30, 2006.
DERIVATIVE CONTRACTS
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivative contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivative contracts that are likely to be used to protect against a
change in an underlying financial instrument, regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts. These derivative
contracts are recorded at fair value, which approximated $4.66 billion at
November 30, 2006.
In connection with these activities, the Company attempts to mitigate its
exposure to market risk by entering into a variety of offsetting
derivative contracts and security positions.
MUNICIPAL SECURITIES
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at November 30, 2006 was approximately $2.98 billion,
which represents the outstanding amount of all trust certificates. This
exposure to loss is mitigated by the underlying municipal bonds. The
underlying municipal bonds in the trusts are either AAA- or AA-rated,
insured or escrowed to maturity. Such bonds had a market value, net of
related hedges, approximating $3.05 billion at November 30, 2006.
RESIDUAL VALUE GUARANTEE
The Company has entered into an operating lease arrangement for its world
headquarters at 383 Madison Avenue in New York City (the "Synthetic
Lease"). Under the terms of the Synthetic Lease, the Company is obligated
to make monthly payments based on the lessor's underlying interest costs.
The Synthetic Lease expires on August 12, 2011
116
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
unless both parties agree to a renewal prior to expiration. At the
expiration date of the Synthetic Lease, the Company has the right to
purchase the building for the amount of the then outstanding indebtedness
of the lessor or to arrange for the sale of the property with the proceeds
of the sale to be used to satisfy the lessor's debt obligation. If the
sale of the property does not generate sufficient proceeds to satisfy the
lessor's debt obligation, the Company is required to fund the shortfall up
to a maximum residual value guarantee. As of November 30, 2006, there was
no expected shortfall and the maximum residual value guarantee
approximated $570 million.
INDEMNIFICATIONS
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third-party
originators upon acquisition of such assets. The Company generally
performs due diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to certain counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a rule
change or an adverse application of certain tax laws. These
indemnifications generally are standard contractual terms and are entered
into in the normal course of business. Generally, there are no stated or
notional amounts included in these indemnifications, and the contingencies
triggering the obligation to indemnify are not expected to occur.
Maximum payout information under these indemnifications is not readily
available because of the number, size and maturities of these
transactions. In implementing this accounting interpretation, the Company
reviewed its experience with the indemnifications on these structures.
Based on such experience, it is unlikely that the Company will have to
make significant payments under these arrangements.
OTHER GUARANTEES
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Additionally, if a member becomes unable to
satisfy its obligations to the clearinghouse, other members would be
required to meet the associated shortfalls. To mitigate these performance
risks, the exchanges and clearinghouses often require members to post
collateral. The Company's maximum potential liability under these
arrangements cannot be quantified. However, the potential for the Company
to be required to make payments under these arrangements is remote.
Accordingly, no contingent liability is recorded in the consolidated
financial statements for these arrangements.
19. SEGMENT AND GEOGRAPHIC AREA DATA
The Company operates in three principal segments -- Capital Markets,
Global Clearing Services and Wealth Management. These segments offer
different products and services and are managed separately as different
levels and types of expertise are required to effectively manage the
segments' transactions.
The Capital Markets segment is comprised of the institutional equities,
fixed income and investment banking areas. The Capital Markets segment
operates as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver these
product services to institutional and corporate clients.
Institutional equities consists of sales, trading and research, in areas
such as domestic and international equities, block trading,
over-the-counter equities, equity derivatives, energy and commodity
activities, risk and convertible arbitrage and through a majority-owned
joint venture, specialist activities on the NYSE, AMEX and ISE. Fixed
income includes sales, trading, origination and research provided to
institutional clients across a variety of products such as mortgage- and
asset-backed securities, corporate and government bonds, municipal
117
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
bonds, high yield products, including bank and bridge loans, foreign
exchange and interest rate and credit derivatives. Investment banking
provides services in capital raising, strategic advice, mergers and
acquisitions and merchant banking. Capital raising encompasses the
Company's underwriting of equity, investment grade, municipal and high
yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the US and
abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are allocated based upon specific criteria or agreed-upon rates with such
amounts eliminated in consolidation. Individual segments also include
revenues and expenses relating to various items, including corporate
overhead and interest, which are internally allocated by the Company
primarily based on balance sheet usage or expense levels. The Company
generally evaluates performance of the segments based on net revenues and
profit or loss before provision for income taxes.
118
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
Fiscal Years Ended November 30, 2006 2005 2004
--------------------------------------------------------------------------
(in thousands)
--------------------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional equities $ 1,961,769 $ 1,445,907 $ 1,087,819
Fixed income 4,189,879 3,293,044 3,147,261
Investment banking 1,169,505 983,044 1,070,048
--------------------------------------------------------------------------
Total Capital Markets 7,321,153 5,721,995 5,305,128
Global Clearing Services 1,076,997 1,028,864 894,333
Wealth Management
Private client services(1) 522,254 452,948 442,247
Asset management 335,474 227,572 185,768
--------------------------------------------------------------------------
Total Wealth Management 857,728 680,520 628,015
Other(2) (28,713) (20,585) (14,593)
--------------------------------------------------------------------------
Total net revenues $ 9,227,165 $ 7,410,794 $ 6,812,883
==========================================================================
PRE-TAX INCOME
Capital Markets $ 2,800,506 $ 2,020,484 $ 1,914,917
Global Clearing Services 464,519 471,796 349,922
Wealth Management 69,160 36,770 62,344
Other(3) (187,555) (321,991) (305,029)
--------------------------------------------------------------------------
Total pre-tax income $ 3,146,630 $ 2,207,059 $ 2,022,154
==========================================================================
NET INTEREST REVENUES
Capital Markets $ 350,256 $ 172,056 $ 81,604
Global Clearing Services 802,554 735,772 568,541
Wealth Management 58,965 57,538 58,151
--------------------------------------------------------------------------
Total net interest revenues $ 1,211,775 $ 965,366 $ 708,296
==========================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
(1) Private client services detail:
Gross revenues, before
transfer to Capital
Markets segment $ 620,337 $ 546,534 $ 527,127
Revenue transferred to Capital
Markets segment (98,083) (93,586) (84,880)
----------------------------------------
Private client services
net revenues $ 522,254 $ 452,948 $ 442,247
(2) Includes consolidation and elimination entries.
(3) Includes certain legal costs and costs related to the CAP Plan, which
approximate $154.0 million, $144.0 million and $176.0 million for the
fiscal years ended November 30, 2006, 2005 and 2004, respectively.
As of November 30, 2006 2005 2004
--------------------------------------------------------------------------
(in thousands)
SEGMENT ASSETS
Capital Markets $240,448,857 $191,932,128 $154,433,465
Global Clearing Services 98,532,526 83,643,297 86,664,127
Wealth Management 3,138,239 2,751,749 2,679,697
Other 8,312,973 8,965,463 8,335,402
--------------------------------------------------------------------------
Total segment assets $350,432,595 $287,292,637 $252,112,691
==========================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
119
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
The operations of the Company are conducted primarily in the United States
of America. The Company also maintains offices in Europe, Asia and Latin
America. The following are net revenues, income before provision for
income taxes and assets by geographic region for the fiscal years ended
November 30, 2006, 2005 and 2004:
2006 2005 2004
--------------------------------------------------------------------------
(in thousands)
Net Revenues-US $ 8,006,413 $ 6,487,321 $ 6,172,286
Non-US 1,220,752 923,473 640,597
--------------------------------------------------------------------------
Total net revenues $ 9,227,165 $ 7,410,794 $ 6,812,883
==========================================================================
Income before provision
for income taxes-US $ 2,668,463 $ 1,867,781 $ 1,875,070
Non-US 478,167 339,278 147,084
--------------------------------------------------------------------------
Total income before
provision for
income taxes $ 3,146,630 $ 2,207,059 $ 2,022,154
==========================================================================
Total Assets-US $ 437,418,643 $ 344,757,169 $ 329,307,806
Non-US 92,836,337 70,436,123 54,517,734
Eliminations (179,822,385) (127,900,655) (131,712,849)
--------------------------------------------------------------------------
Total assets $ 350,432,595 $ 287,292,637 $ 252,112,691
==========================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Because of the international nature of the financial markets and the
resultant integration of US and non-US services, it is difficult to
precisely separate foreign operations. The Company conducts and manages
these activities with a view toward the profitability of the Company as a
whole. Accordingly, the foreign operations information is, of necessity,
based on management judgments and internal allocations. Included within
the Company's US net revenues during fiscal 2006 and fiscal 2005 are the
revenues of Bear Wagner Specialists LLC.
120
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
continued
20. QUARTERLY INFORMATION (UNAUDITED)
The unaudited quarterly results of operations of the Company for the
fiscal years ended November 30, 2006 and 2005 are prepared in conformity
with accounting principles generally accepted in the United States of
America, which include industry practices, and reflect all adjustments
that are, in the opinion of management, necessary for a fair presentation
of the results of operations for the periods presented. Results of any
interim period are not necessarily indicative of results for a full year.
Quarters Ended,
----------------------------------------------------------------
February 28, May 31, August 31, November 30,
2006 2006 2006 2006 Total
-----------------------------------------------------------------------------------------
(in thousands, except per share data)
Revenues $3,638,418 $4,303,749 $4,135,687 $4,473,565 $16,551,419
Interest expense 1,453,215 1,804,307 2,006,552 2,060,180 7,324,254
-----------------------------------------------------------------------------------------
Revenues, net of
interest expense 2,185,203 2,499,442 2,129,135 2,413,385 9,227,165
=========================================================================================
Non-interest expenses
Employee compensation
and benefits 1,046,850 1,220,216 1,024,748 1,051,685 4,343,499
Other 386,000 445,027 437,149 468,860 1,737,036
-----------------------------------------------------------------------------------------
Total non-interest
expenses 1,432,850 1,665,243 1,461,897 1,520,545 6,080,535
-----------------------------------------------------------------------------------------
Income before
provision for
income taxes 752,353 834,199 667,238 892,840 3,146,630
Provision for
income taxes 238,197 294,866 229,682 330,014 1,092,759
-----------------------------------------------------------------------------------------
Net income $ 514,156 $ 539,333 $ 437,556 $ 562,826 $ 2,053,871
=========================================================================================
Basic earnings
per share(1) $ 3.92 $ 4.12 $ 3.34 $ 4.42 $ 15.79
Diluted earnings
per share(1) $ 3.54 $ 3.72 $ 3.02 $ 4.00 $ 14.27
=========================================================================================
Cash dividends
declared per
common share $ 0.28 $ 0.28 $ 0.28 $ 0.28 $ 1.12
=========================================================================================
Quarters Ended,
----------------------------------------------------------------
February 28, May 31, August 31, November 30,
2005 2005 2005 2005 Total
-----------------------------------------------------------------------------------------------
(in thousands, except per share data)
Revenues $2,622,369 $2,823,580 $2,925,394 $3,181,104 $11,552,447
Interest expense 784,709 950,028 1,113,114 1,293,802 4,141,653
-----------------------------------------------------------------------------------------------
Revenues, net of
interest expense 1,837,660 1,873,552 1,812,280 1,887,302 7,410,794
===============================================================================================
Non-interest expenses
Employee compensation
and benefits 906,775 922,908 850,985 872,548 3,553,216
Other 352,557 488,205 381,140 428,617 1,650,519
-----------------------------------------------------------------------------------------------
Total non-interest expenses 1,259,332 1,411,113 1,232,125 1,301,165 5,203,735
-----------------------------------------------------------------------------------------------
Income before provision
for income taxes 578,328 462,439 580,155 586,137 2,207,059
Provision for income taxes 199,523 164,329 201,850 179,180 744,882
-----------------------------------------------------------------------------------------------
Net income $ 378,805 $ 298,110 $ 378,305 $ 406,957 $ 1,462,177
===============================================================================================
Basic earnings per share(1) $ 2.94 $ 2.32 $ 2.96 $ 3.21 $ 11.42
Diluted earnings per share(1) $ 2.64 $ 2.09 $ 2.69 $ 2.90 $ 10.31
===============================================================================================
Cash dividends
declared per common share $ 0.25 $ 0.25 $ 0.25 $ 0.25 $ 1.00
===============================================================================================
(1) Due to rounding and/or the effect of averaging the number of shares of
common stock and common stock equivalents throughout the year, the sum of
the quarters' earnings per share amounts does not equal the full fiscal
year amount.
121
THE BEAR STEARNS COMPANIES INC.
CORPORATE INFORMATION
PRICE RANGE OF COMMON STOCK AND DIVIDENDS AND RELATED STOCKHOLDER MATTERS
The common stock of the Company is traded on the NYSE under the symbol BSC. The
table below sets forth for the periods indicated the closing high and low prices
for the common stock and the cash dividends declared on the common stock.
As of February 5, 2007, there were 1,509 holders of record of the Company's
common stock. On February 5, 2007, the last reported sales price of the
Company's common stock was $165.06.
Dividends are payable on January 15, April 15, July 15 and October 15 in each
year on the Company's outstanding Cumulative Preferred Stock, Series E;
Cumulative Preferred Stock, Series F; and Cumulative Preferred Stock, Series G
(collectively, the "Preferred Stock"). The terms of the Preferred Stock require
that all accrued dividends in arrears be paid prior to the payment of any
dividends on the common stock.
Since the Company is a holding company, its ability to pay dividends is limited
by the ability of its subsidiaries to pay dividends and to make advances to the
Company. See Note 16, "Regulatory Requirements," in the Notes to Consolidated
Financial Statements for a further description of the restrictions on dividends.
Cash Dividends
Declared Per
High Low Common Share
- --------------------------------------------------------------------------------
FISCAL YEAR ENDED NOVEMBER 30, 2006
First Quarter (through February 28, 2006) $136.40 $110.50 $ 0.28
Second Quarter (through May 31, 2006) 147.07 127.28 0.28
Third Quarter (through August 31, 2006) 145.49 123.43 0.28
Fourth Quarter (through November 30, 2006) 158.60 128.07 0.28
FISCAL YEAR ENDED NOVEMBER 30, 2005
First Quarter (through February 28, 2005) $106.68 $ 96.65 $ 0.25
Second Quarter (through May 31, 2005) 106.03 93.09 0.25
Third Quarter (through August 31, 2005) 107.21 97.96 0.25
Fourth Quarter (through November 30, 2005) 114.47 101.46 0.25
PERFORMANCE GRAPH
The following graph compares the performance of an investment in the
Company's Common Stock over the last five fiscal years with its Peer Group, the
S&P 500 Investment Banking & Brokerage Index and the S&P 500 Index. The entities
included in the Company's Peer Group consist of Merrill Lynch & Co., Inc.,
Morgan Stanley, The Goldman Sachs Group, Inc. and Lehman Brothers Holdings Inc.
The performance graph assumes the value of the investment in the Company's
Common Stock and each index was $100 on November 30, 2001, and that all
dividends have been reinvested. The performance shown in the graph represents
past performance and should not be considered an indication of future
performance.
COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN
[The following table was depicted as a line graph in the printed material.]
2001 2002 2003 2004 2005 2006
------- ------- ------- ------- ------- -------
The Bear Stearns Companies Inc. $100.00 $112.45 $128.71 $175.06 $201.11 $278.52
Peer Group 100.00 87.08 109.57 112.25 140.53 194.96
S&P 500 Investment Banking & Brokerage Index 100.00 83.99 103.26 106.25 129.48 179.02
S&P 500 Index 100.00 83.49 96.08 108.44 117.59 134.33
122